Growth in Multi-Strategy Hedge Funds

Additional content provided by Michael McClain, AVP, Research.

Over the past several years, inflows and interest in the hedge fund industry has been overshadowed by growth in private markets — specifically in credit strategies; however, multi-strategy hedge funds have been one of the sole bright spots in the alternative investment strategy landscape.  

Multi-Strategy Benefits  

Multi-strategy hedge funds benefit from their ability to allocate capital across distinct investment strategies or “pods” to achieve their goals. Depending on the size of the firm, there may be dozens of pods within a fund. By allocating to independent trading teams, each focusing on different strategies and asset classes free from a house investment view, these funds ideally may provide a diversified return stream focused on alpha generation (a measure of an investment's performance relative to a benchmark index, adjusted for risk), rather than beta exposure (risk relative to the overall market). This also allows greater flexibility in allocating capital to the most attractive areas of the market.  

For example, a market environment featuring more active central bank rate shifts would be attractive for macro pods specializing in bonds and currencies. However, against a backdrop of greater equity market volatility and dispersion, capital should be allocated to long/short or equity market-neutral stock pickers. These shifts in allocations are also within the confines of a single firm, so capital can be more quickly moved into areas of opportunity, rather than needing to redeem and redeploy to another fund.  

Leverage and Fees 

Multi-strategy firms are not without risk, which can be seen in recent headlines surrounding losses from index rebalancing pods. This type of strategy attempts to profit from expected changes to an index, as they go long stocks being added to an index or those expected to have an increase in weight and short those expected to have a lower weight going forward. An increase in market volatility at the time of the rebalancing, combined with significant use of leverage, led to steep losses. Ideally, an index rebalancing strategy should churn out smaller, consistent gains through the use of prudent leverage. Additionally, the use of pass-through fee structures, which allows a firm to charge investors a variable fee that may include ongoing compensation and bonus, travel, savings plans etc., has also become the norm and can have a significant impact on the end profits retained by investors. A typical compensation agreement would involve a pod portfolio manager receiving a percentage of what they generated in profits. Today, it’s difficult to gauge a standard level of leverage (easily mid-single digits for some strategies) and end fees charged to clients, however, together they will have the most meaningful impact on an investor’s long-term results.  

LPL View 

LPL Research maintains a positive view on multi-strategy funds given their history of providing returns independent of equity and bond markets and their ability to dynamically allocate across often hard-to-access investment strategies in a single fund structure. Steep drawdowns have also been avoided over time given their focus on risk management, trading across assets both long and short, and reducing capital to pods experiencing losses. 

Given their risk profile, an allocation can be sourced from existing equity or bond exposure, however, it should be noted in a strong bull market, these strategies would be expected to underperform given their focus on pure alpha generation, with limited beta exposure.  

Multi-strategy hedge funds combine uncorrelated hedge fund exposures in one investment vehicle, employing dynamic asset allocation that allows flexibility to respond to market events.