Beat the Pods: A 7-Point Recipe For Single Managers
There has been some lively discussion recently about the trend from single-manager hedge funds (SMs) to multi-manager hedge funds (MMs or "pods"). Which is very sensical after a year like 2022 where there was a big performance differential between most pods and most SMs. With many SMs well below high water marks, a year like '22 can also accelerate talent flow to MMs.
In my career, I had the educational experience of working at a very well-run single-manager fund as well as three well-run and well-known multi-PM funds. In my role now at Fundamental Edge, I have the pleasure of working with many top multi-PM funds and single-PM funds. Nothing here will be specific to any of these funds, but simply my high-level observations and personal opinions.
I had a friend at an SM fund a couple of weeks ago ask me "Brett, you've worked at both, what advice would you give to SM's to compete against MM's?". I also listened to Vinny & Porter's podcast talking about using their learnings from Citadel to accelerate their family office investing returns. Both got me thinking, and I'm in the process of developing a 100+ page deck with some structured thoughts to do some consulting with funds working through this change in the investment ecosystem.
The following thoughts are a first draft, which I will refine over time. I highly welcome your feedback since it helps me improve my thinking.
A recipe to compete when "pods are eating the world".
KEEP YOUR TALENT
To be honest, you expected point 1 to be "leverage time arbitrage" right? I'll get to that point. But in the SM vs. MM market share game, the foundational job of an SM GP/CIO is to keep your team. The hedge fund world is unique in that even large, well-known single managers might only have investment teams of 6-15 people. And if you've lived in that world, you know that there are often 3-5 truly special investment professionals in that group who have that "nose for money" and are consistent money-makers.
I've seen plenty of SM funds gutted by losing talent to MMs. If the firm has a good culture and internal training and development, a "next person up" approach can work. But the turnover of your A+ talent in the ultimate human capital endeavor - investing - is costly and risky.\
My advice? Practice preventative maintenance with your talent. The old paradigm of "you should be lucky to work here and I'll pay you whatever I decide to pay you" for a talented 4-7+ year proven money-maker just doesn't work anymore. The pods will give that person a $500m-$1bn+ portfolio, 15%+ payout, usually some nice up-front money, and the autonomy and alignment that the money-maker desires.
The pitch is compelling, and lots of the top SM talent is biting. What shines is not always gold, but we will get to that part. How do you compete? Money is an obvious vector here. But very few SMs will compete with the bull case for a PM at an MM (i.e. if you build a portfolio to $2bn and make 5% on that you are consistently taking home $10m+ as the PM). And by the time that person has accepted the MM seat, more money isn't likely to sway them (and can set a bad precedent).
What I think matters more is alignment, visibility, a sense of partnership, and a shared mission. If you have an investment team of 12, who are the 3-4 on that team you absolutely don't want to lose (CIOs, you know who those are). Maybe make them a partner in the fund. Give them a contractual share in the management fee. Give them a 3-year comp plan with P&L contingencies. Your job is to try to create more visibility and confidence in compensation outlook so that the analyst views the SM seat as a higher multiple, more durable comp stream that that person can build a nice life around, even if that comp level falls short of the MM bull case (which it will).
Also, the soft stuff is the big stuff. Celebrate your team's life events, encourage them to bring their kids to the office, and do off-sites and outings. Make it a "special" place to work and bring humanity into the day-to-day.
Understand burnout is a common thing in the 4-7 year range and sometimes burnout leads to exploring new pastures. Consider a sabbatical offering. I honestly loved the part of moving jobs where I got to take 1-2 months off between seats. Build that into your talent development plan. Work to really articulate the pros & cons of the SM vs. MM seat. Tactfully walk through the risk of the MM seat - drawdowns, risk model constraints, top-line cost flow-throughs, high turnover, etc. This is where I think our content will hopefully be helpful to our clients as we break down the MM approach in excruciating detail.
And if all else fails, and you really lose a star, keep an open door. If it were me, I'd let them know they have a seat when they want it. The grass looks greener for them right now, but when they get caught in a 200bps drawdown for positioning reasons, get a capital cut and 2 analysts quit...the grass doesn't look so green. Make it easy for them to come back. And, by the way, the pressure cooker of understanding that way to invest is likely to make them a monster upon return.
TIME ARBITRAGE
This one isn't surprising, but it's true. In my MM teams, I always felt like we had a really good sense of the 9-18-month winners, but it is very hard to express those trades and stick with them. I can't just be long UNH, short WBA, and wait it out - particularly if UNH is going to have a 10% pullback and WBA is going to beat a quarter and squeeze. I run through this math in my deck, but a 20% drawdown on a 15% of LMV (long market value) position in a $50 vol, $1.5bn GMV book ALONE will hit my 150bps drawdown trigger and give me a capital cut. I simply cannot bear that risk as an MM PM - it is existential, as I then need a full 3% / 1-sharpe performance on my 50% book size just to get back to even.
What does that mean in simplistic terms? If I think there is a chance a stock goes down 15-25% before it goes up, I either can't own it or I can't own it in size. With more capital flowing to MMs, and that mathematical constraint true across the board, this behavior starts to create distortions to the price discovery mechanism in the markets.
How does that manifest? Via big overreactions to near-term squishiness. Maybe a good company with a good 3-year story is going to miss a quarter, and due to that overhang, the company has underperformed by 15-20%. Have a bias to lean into those trades.
The hero MM PM makes money 9-10 out of 12 months and limits losing months to under 100bps. That is done via a very sharp process around identifying inflections, revisions, and catalyst-driven narrative shifts. Find the "cheap but no catalyst" stories. Or sometimes, the play might be, figure out when pods might want to buy the story and be there 3-6 months before.
I came to LOVE situations where there was an obvious catalyst, but the catalyst wasn't coming for 4-6 months. Believe it or not, many traders won't wait that long, but the IRR of waiting can be really superb.
CONCENTRATE
I am bearish on single-manager portfolios of yesteryear with 150+ positions. That is too many, in my mind. Markets are growing inescapably more efficient with alpha windows tighter and alpha pools more shallow. How wide is the alpha load on position 150 in that portfolio? I would submit not wide at all. If 75% of stocks were fairly valued a decade ago, my guess is that is 90% today.
There will always be anomalies and inefficiencies in markets, but the ecology of players has shifted. The quotient of "dumb money" has decreased due to the secular trend of indexing. Between quants arbitraging systematic, observable anomalies and pods arbitraging inflections and revisions, applying their data- and corporate access-driven approach, anomalies are smaller. So the bar should be higher for ideas in your portfolio.
Concentration, to me, is the only way for SMs to survive. Find your great ideas and act decisively. I strongly believe the days of the 40-person, 7-sector single manager 2 & 20 hedge fund are over. Markets won't allow that model to work anymore. The future for SM is smaller, nimbler teams with concentrated portfolios and low latency, decisive decision-making. It's the only way.
WHERE POSSIBLE, ALPHA ISOLATE
Limited Partners (investors in hedge funds) have become much more sophisticated over the last decade. Particularly around factor attribution. The MM's are true "alpha factories" in that the return stream is primarily idiosyncratic vs. systematic. That might seem academic, but in a year like 2022 when beta, investor overlay, and long-term momentum smashed returns at Tiger Cubs, it becomes not so academic.
MM's performed well last year by using market volatility to exploit idiosyncratic mispricings. If I'm an LP, that's EXACTLY why I'm paying 2 & 20. I don't want to pay 2 & 20 for a HF portfolio to give me beta and exposure being long LT Mo and short residual volatility. I can do that now with factor baskets. I can buy the Goldman VIP ETF. You have to give me something I can't get somewhere else for cheaper.
My advice - get a risk model. There are now some vendors who offer off-the-shelf risk models that are as good or better than existing at MMs (Equity Data Science is one of our speakers in the Academy). Learn to understand the risk decomposition in your portfolio, and learn to do an attribution analysis for your LPs. The good ones will ask for this. My advice would be, if possible, to use a portfolio construction approach with a 60-65%+ beta-neutralized idiosyncratic bar with as low as possible correlation to the S&P 500 and GS VIP. If I'm an LP building a portfolio of hedge funds, that's what I want in my stable.
RECONTEXTUALIZE EARNINGS.
Given the desire to be a positive P&L generator in 9 out of 12 months, and given the drawdown risk characteristics inherent in the 400-600% gross leverage wrapper, earnings season becomes a critical catalyst event for MM portfolios. And not just print day, but the run-up and post-print mis-pricings. At an MM, PMs live for earnings season. The print-to-print activity was all with an eye toward the next earnings catalyst.
Modeling, channel checks, calls with the sell-side, 2-4 interactions with corporates each quarter, and the earnings preview process were all done with an eye toward monetizing the volatility inherent in earnings season (print days are 2% of a year's trading days but generate ~20% of idiosyncratic volatility).
What does that detailed process mean for SMs? Well, earning prints are the ultimate moving bar, the ultimate expectations gap game. There is simply a low chance you are going to compete and win this game consistently in today's market - even if you wanted to, the massive sell-side wallet at MM firms gets them top priority in corporate access and sell-side access. Throw in multi-million dollar alt data budgets and it is an arms race that very few SMs can compete in.
My advice would be to try to re-contextualize earnings as a primarily defensive-minded period where the understanding is the SM team might not have the full context of expectations. That seems disempowering, but the alternative of spending ~50% of your research time on the earnings cycle seems like a bad decision too. Listen, will a huge NVDA-like Q1 beat and raise still move stocks? Yes, obviously. Find the inflection in your thesis and understand the catalyst path. But know that if, increasingly, you don't understand price movement in your space on print day - that's ok. Use earnings as thesis check-in. Perhaps do some positioning work (via MM PM friends or spec sales) and look for counter-positioning moves to fade. Company misses MM whisper and gets hate-sold? Take advantage of those counter-positioning moves to leg into positions you like. More reaction than predicted would be my advice.
GO WHERE THEY AIN'T
Try to understand where pods play to better understand the ecology and alpha pools. Pods generally will like three things.:
1. Highly liquid stocks
2. Catalyst-rich situations, particularly latent revision potential
3. Tangible/reliable downside
The lifeblood of the MM model is liquidity. I need liquidity for a couple of reasons.
1. I need to risk managing my book in a kerfuffle so I don't get my capital cut. I can't do that if I am 5 days of volume.
2. I am turning over my book 5-10x per year, so with shorter trades I need to get in and out quickly.
Generally, my experience trading large portfolios is that anything north of 2-3% of daily volume (outside of a natural cross) starts to create slippage, i.e. I'm pushing a stock up or down. For a 10% LMV position on a $1.5bn book ($75m position), even if that stock trades $100m ADV, that is taking me 33 days to enter, and 33 days to exit with minimal slippage.
What does that mean? It means that I might cover 250 stocks on my team, but I REALLY want to cover the most liquid 50. That is really where my P&L is coming from. I will still cover $25-$75m names, but anything under $50m and certainly anything under $25m starts to become very difficult to enter & exit, particularly if I am wrong on a trade and get stuck.
My belief is that the trend toward MM HF's will hollow out the $5-50m ADV competitive set and paradoxically make this a reliable alpha opportunity for the remaining single manager funds. On revisions, understand that in most sectors the forward trajectory of EPS revisions is deterministic to stock price returns, with some exceptions. A more creative, value-driven mindset can surface ideas where the revisions and stock prices might diverge.
FADE VOLATILITY
My sense is that there is now over $1tn of gross capital deployed in the "short part of the alpha curve" volatility-budgeted, market-neutral HF strategies. What are the implications? Well, when a volatility event happens and I have a 1.5-3% drawdown, i.e. my longs go down and my shorts go up, I more likely than not will have to exit that trade after it has gone against me. In a MM, wrapper gross capital effectively becomes pro-cyclical with returns.
From the Tiger's perspective on things (i.e. "if I like a stock and it goes down for a stupid reason I like it more"), this is nonsensical. If my longs go down 3% and my shorts go up 3%, I should take gross exposure higher. But...LEVERAGE. It is generally believed that MM funds will run with 400-600% gross exposure.
Basically, an MM hedge fund is like your typical 20% down buyer on a house - if the house value goes down 10%, I'm not down 10%, I'm down 50%. Leverage accelerates outcomes, and in an MM context turns 3% returns on gross into 15% returns on equity via the acceleration dynamics of leverage.
What does this mean in practice? Well, if leveraged players have a drawdown, their reaction to that drawdown is likely to actually ACCELERATE that drawdown via the de-grossing of portfolios. If you've spent any time trading the last decade, you know the intensity & frequency of these de-grossing kerfuffles are only increasing. This is just a math problem. If I run a big book at a pod and I have a 3% drawdown and the pod doubled my book from $2bn to $4bn to try to take advantage of that drawdown and I'm down ANOTHER 3%, it's a huge problem. A risk these funds can't and generally won't take. So there is a systemic risk approach to limit left tail outcomes by truncating your PMs who are underperforming. And it's worked at the GP level beautifully, so I wouldn't expect that to change (if anything, more replicators will come).
What does that mean for you, dear single manager? These kerfuffles are your friend. Learn to identify them and monetize them. You are the only player at the table who has the capital to step into this kerfuffle. Do the work, but don't be afraid to fade a kerfuffle. Preferably on a beta-limited way, looking for blown-out spreads. There are different ways I've monitored for kerfuffle and spread-blow outs and I am building that into my content.
UNDERSTAND THE ECOLOGY (bonus)
Don't have your head in the sand with regard to the other players in the market. Great poker players study their opponents more than they study the cards - their approach to the game changes based on who is at the table. Annie Duke was a guest speaker at analyst training and told us to "run the nuts" against retail investors, and play the obvious hand when presented (that's worked beautifully on AMC and GME). But the poker game changes when you are at a 12-top full of pros. Their tendencies and tells are harder to glean. The same is true in markets in 2023.
When Buffett started investing professionally in 1956, there were virtually no investors doing fundamental analysis. Reading a 10-K was an alpha generator. When Julian Robertson started investing professionally in 1980 the fundamental investing hedge fund industry was a cottage industry. You could have a massive informational edge simply with some effort.
The ecology is different in 2023. The hedge fund industry is $4.5tn+ with over 12,000 funds in the US alone. Information is distributed more uniformly. Quants have eaten the alpha on Buffett's favorite factors and turned those factors into beta. And thousands and thousands of sharks are out there looking for any sign of an edge.
My advice: study the players at the table. Understand the incremental buyer of your position - who are you selling it to? Work to understand when the MM, when the SM, when the LO might want to get involved. And, importantly, spend time trying to understand how the shifting capital players create new anomalies in the market.
For example, the indexing wave has created a large alpha opportunity for index rebalance. It is my belief that the shift to MM biz models in the HF industry is secular, not cyclical. Shared overheads, risk diffusion (P&L is additive and risk is the sum of squares), and the challenges of a SM launch all align to support the view that the MM model is here to stay. But out of that trend, I also believe that new alpha opportunities will emerge for the enterprising, adaptive single manager.
If you've read to this point, damn that ended up being a LOT longer than I expected it to be. I'd love your thoughts & feedback. If you are a SM or MM who thought any of this is helpful, please e-mail me at brett@fundamentedge.com.