Multi-strategy hedge funds have a lot to offer for investors who are looking to build a diversified hedge fund portfolio. However, building an allocation is not without its challenges, say Pravir Sharma, Senior Associate and Toby Goodworth, Managing Director and Head of Liquid Markets at bfinance.
Multi-strategy hedge funds are currently in vogue following the recent success of several high-profile names, and notably those larger US platform ‘multi-strat’ funds.
The strategy was one of only two hedge fund strategies to attract inflows in 2022, drawing in almost $6 billion, while investors ripped $111 billion out of the broader hedge fund universe in the year, according to eVestment. Not only that, but multi-strategy hedge funds were described as “the new, superior fund-of-funds” by Robin Wigglesworth, Editor of Alphaville, in October – quite the compliment. And this recent success leaves multi-strat on the brink of overtaking long-short equity as the largest hedge fund strategy, which can only be expected to grow in popularity as across the hedge fund universe, there are more than 1000 managers self-classifying as ‘multi-strategy’, according to a leading commercial database.
A closer look at multi-strategy hedge funds
At a generalised level, multi-strategy hedge funds come in two flavours: ‘pod shop’ platforms, in which the various underlying portfolio managers essentially function independently and share little or no information with each other; and ‘one-book’ strategies with a single profit and loss and more collaboration across portfolio managers. In either case, a ‘lead’ portfolio manager or an Investment Committee tactically allocates risk to the underlying strategies. Multi-strategy funds are characterised by adhering to very strong risk management frameworks—more so, perhaps, than any other hedge fund strategy. Often here, it is the risk management and portfolio allocation process that investors are buying into, as the underlying portfolio managers and detailed insights into sub-strategies are not visible.
The investment approaches taken by multi-strategy hedge funds can also vary. Investors have the choice between quantitative approaches, discretionary approaches or those that blend both quantitative and discretionary styles together.
Although these strategies typically seek to maximise risk-adjusted returns, one of their most appealing features is not outright return (although that has been helpful recently), rather their ability to offer a consistent stream of returns that is not correlated with traditional markets, and so does not suffer from the same challenges or struggle through periods of market stress. They typically operate with volatility in the mid-to-high single digits and aim for a Sharpe ratio of 1 or above (a high hurdle, even within the hedge fund space). The sub-strategies that comprise a multi-strategy hedge fund will be selected based on the extent to which they complement every other sub-strategy, ensuring that the portfolio is also diversified within itself.
This variety of elements – market-dependent and market-independent, convex and directional – is intended to support an ‘all-weather’ return profile. What is the reason behind this recent momentum and, more importantly, is it warranted?
Returns in Focus
Well, for starters, multi-strategy hedge funds offer investors diversified hedge fund exposures without the resource burden involved in single manager allocations or the visible dual layer of fees associated with other fund of hedge funds strategies – i.e. convenience. And they also provide a highly dynamic approach to asset allocation and risk capital exposure, which in turn improves flexibility and reactivity in times of market stress – i.e. performance consistency – a factor that has become more desirable to investors over the past 18 months.
Since 2000, the Eurekahedge Multi-Strategy Hedge Fund Index has managed to deliver 8.3% on an annualised basis – a return level that would typically be expected to satisfy even the most aggressive investor strategic asset allocation expectations. But the strategy also offers strong risk management controls which ensure that individual strategies do not consume the risk budget and dominate returns. It will not be surprising to many investors to learn that traditional markets, think equities and bonds, have – and continue to – endure rather challenging environments, but the multiple drivers of return in one product quality possessed by multi-strategy hedge funds can prove particularly beneficial during times of equity market stress.
For the more experienced portfolio managers, a multi-strategy shop can offer an environment where top performers can obtain a degree of autonomy and stability, focusing on their core investment work without the distractions of fundraising and firm management.
Issues associated with multi-strategy hedge funds
It's crucial that investors do not underestimate the challenges associated with these strategies. As always, popularity carries its own set of problems. These types of strategies can often prove expensive; management and performance fees are relatively high, and there appears to be a growing use of ‘pass-through’ fees, which are not particularly investor friendly. Typically, when analysing financial markets, historical data can be a valuable tool when forecasting. However, within the multi-strategy hedge fund space, track records are far less representative because of their highly dynamic approach – the investor is buying a return stream and a disciplined risk management process, not a strategy as such, and so gaining conviction in manager selection can be difficult.A number of successful managers in the space also appear to suffer from capacity constraints, which makes it harder to access and negotiate competitive terms, which is further underlined by the ‘war for talent’ in the sector, essentially meaning that there is a high degree of turnover in the underlying portfolio manager base. It can be difficult to navigate the roster of strategies: more than 1000 providers self-define as ‘multi-strategy hedge funds’ in industry databases, as mentioned above, since all that is required by such databases is that more than one hedge fund strategy be included in a given product.
Is this strategy right for you? They are certainly worth exploring – particularly while markets are still uncertain – but, as with any investment, it is crucial to understand the pros and cons associated with it before making any commitments.
Pravir Sharma is a Senior Associate at bfinance
Toby Goodworth is Managing Director and Head of Liquid Markets at bfinance