The hedge fund industry has gone through multiple evolutions. Investing styles go in and out of fashion as market conditions change. Strategies that work become crowded with investors, which can mean they stop working as well. The hottest thing these days are so-called multi-strategy funds or "pod shops" that employ multiple distinct teams, each with a specific mandate, style and edge. In theory, with good risk management and internal capital allocation, this can produce robust results across many cycles. So how do these funds work, how are they making money, and what does the expansive growth of this new style of fund mean for markets? In this episode, we speak with Krishna Kumar, a portfolio manager at Goose Hollow Capital Management, about the rise of multi-strategy hedge funds, why they're so popular, and how the increasing amount of money deployed by these firms is changing the way that markets trade. This transcript has been lightly edited for clarity.
Key insights from the pod:
What is a pod shop? — 4:59
What makes a multi-strategy firm successful? — 6:35
Why have they gotten so popular? — 10:32
How the funds are affected by the rising cost of leverage — 14:02
How do muli-strat funds exercise risk management? — 16:39
What pod managers are optimizing for? — 25:27
The influence of ETFs in the market — 27:55
How managers survive inside pod shops — 30:12
How do you measure drawdowns? — 33:24
Are there macro risks from these funds? — 37:30
Can these funds continue to outperform? — 40:36
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Joe Weisenthal (00:17):
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway (00:22):
And I'm Tracy Alloway.
Joe (00:23):
Tracy, have you noticed there have been some crazy moves in the market lately?
Tracy (00:26):
I know, it's kind of funny. If you look at traditional measures of overall volatility in the market, so obviously things like the VIX, it was relatively low up until recently, and that was despite all these big surges in a bunch of stocks. So the mega cap tech companies kind of stand out there.
So I guess overall benchmark moves were kind of low, but if you look within that, if you look at specific single stock performance things like dispersion, it's been kind of crazy – sort of under the surface, there's been a lot going on.
Joe (01:01):
We are recording this February 15th, 2024. Shares of Super Micro, I don't know what they do, I know they do something with AI. They're currently at $951, up $69 a share on the day. On January 18th, they were at $311, so it's a triple in a month. There was Arm Holdings recently, which is like now an $150 billion [company]. I mean, these are like serious high market cap companies...
Tracy (01:29):
Don't you call these upcrashes?
Joe (01:30):
Upcrashes. That's the word that I use. So it's something like, here's just a company that's been around for a while. Mature. People understand it. It was a $65 billion company a couple weeks ago. It's currently a $128 billion company. Just these big fat chunky moves in both directions that we're seeing.
Tracy (01:48):
Yeah, and on the one hand, obviously you can ascribe it all to ‘investors are getting really excited about things like AI,’ and again, a lot of the movement we've seen happen [is] in tech stocks. But on the other hand, it feels like there might be something else going on here. And every once in a while I hear people talking about multi-strategy funds and the impact that those might be having on these overall market moves.
Joe (02:15):
Totally. Like these sort of moves that just keep going in one direction over and over again. Speaking of multi-strategy hedge funds, which we're going to get into and understand how they work, and maybe if they are sort of changing the complexion of how stocks trade these days. I think there've been a lot of launches of them.
So we know that some of them have done really well. And of course we're regaled with the incredible return to Citadel, but I think we're starting to see a lot of people who were at those shops, launched their own multi-strategy shops. So there was a good article too on Bloomberg just this week, talking about like, not only are they proliferating, but for years they talked about how the 2+20 model was fading. Like you and I have probably heard that our whole careers, it's going away because they're taking in more than that and I think they're keeping like half the profits that they make. So like 20% is sort of old hat, so these are huge money making machines now.
Tracy (03:09):
Is this is this Pod Lots? I think it's Pod Lots.
Joe (03:12):
This is the original Pod Lots. Yeah.
Tracy (03:14):
So here's only three things I really know about multi-strategy shops, which is one, they're very hot right now, and as you say, we have seen a lot of launches recently. Two, I think they trade a lot, like just in terms of absolute volume. I think they're very active and becoming increasingly active and a bigger portion of the market. And then three, I hear a lot of talk about measuring performance scientifically and like the things they do differently to maybe a traditional long short fund, but I don't actually know what it means, in detail. And then also as you were saying, I don't actually understand completely ythe market impact. I think there are a lot of different theories at the moment of how they might be impacting the market. So I'm very excited about this conversation.
Joe (04:00):
Yeah. Tons of questions on a big and growing topic that we should talk about more. So I'm excited, we have the perfect guest. We're going to be speaking with Krishna Kumar. He is the founder of Goose Hollow Capital. He previously ran pod capital at the multi-strat hedge fund, MKP. He was also previously at Omega. And he is going to talk about how these places work and the sort of impact they have on how stocks trade. So Krishna, thank you so much for coming on Odd Lots.
Krishna Kumar (04:26):
Hey, excited to be here. Big fan of the show.
Joe (04:29):
What is a pod shop? Let's just start there, because I have some idea of this big fund. This is what I think in my head. You have a big fund with a bunch of money. A bunch of teams, maybe you have like a handful of people on each, all working for themselves. The better the teams do, presumably they get more money, more resources, more capital to trade. If they do badly, they're on a short leash, they can be fired quickly and somehow they make a lot of money with that. But that is probably the extent of what I actually understand about how they work. What are they?
Krishna (04:59):
So if you think about most hedge funds that people talk about, most of them are now multi-strategy funds that are made of bunch of pods underneath. So if you go back in time to the first hedge fund that ever started, A.W. Jones, I mean, that was in some sense a manager with all these underlying analysts who are then picking up, looking at various sectors and running strategies, right? And the evolution of that today, is this monster called the multi-strategy fund. And it's sort of a platform.
So if you think about our economy, we are very good at creating platforms out of things. So if you take Apple as a company, Apple is a platform company. They don't actually produce anything. They come up with ideas, they come up with this Vision Pro, and then they get a bunch of people overseas to make them, and then they market it. So the similar kind of concept in hedge fund space is this idea of a multi-strategy platform, and pods are the units that are working within that platform.
Tracy (06:03):
So you actually worked in a multi-strategy fund at one point, I believe, and I'm curious how that platform idea drives the culture, but then also what exactly is the competitive edge that a multi-strategy fund or a pod shop is offering here? Is it just that ‘we’re able to select the best managers of individual strategies and put them together in one place?’ What makes a successful multi-strategy fund?
Krishna (06:35):
So yeah, this is again a part of the evolution. So if you go back in time, we used to have this construct of single manager hedge funds, which in the nineties were fairly big. And then people said they wanted to get the average hedge fund performance, just like people like to buy the index, they wanted to buy the index of hedge funds. And there wasn't one. So they created something called a fund of funds, which just added fees on fees.
So essentially you had underlying hedge funds, and then there was a fund manager that selected these hedge funds, and they did extremely well from 2000 to 2007. And then in ‘08, all sorts of bad things happened, but what we found out was fund of funds, the earlier iteration of the multi-strategy fund, had all the downside and less of the upside. Because what we had in 2008 was a lot of the underlying managers did poorly and people just wanted to get out of hedge funds as a whole.
And the hedge funds started to gate all these investors. And then the fund of funds, which were one level removed from them, also gated the underlying investors, right? So that created this whole thing where fund of funds as a concept became not a great idea. And so the next version of that now, is this multi-strategy fund. Essentially you want to get an index of different managers’ returns, and you don't have the ability to do that yourself, so you go to a multi-strategy platform and you end up getting a whole bunch of managers as a composite.
Tracy (08:14):
Oh, I see. So it's not necessarily outperformance, although there are a lot of multi-strategy funds out there that seem to be outperforming, but more the diversification benefits.
Krishna (08:24):
Yeah, I think it is. I mean, if you think about the average multi-strategy fund, they have lots of uncorrelated strategies, right? So they have, you know, a typical multi-strategy fund, the core of it is some sort of quant strategy, like a stat-arb strategy. Pretty much every large multi-strategy fund is built around that. And then you have fixed income RV, credit RV, macro RV, and then macro directional, which is what I do.
And all of that is put together into a composite performance profile. So given that all these strategies are sort of orthogonal, over time you tend to benefit from the lack of correlation. And that's one of the biggest benefits that investors see when they allocate to multi-strategy funds.
Joe (09:11):
So someone sets up the pod shop, someone runs the whole platform, so to speak, and brings in fund managers and fires fund managers who are doing these different strategies. What does that person have to be good at for the platform to work?
Krishna (09:27):
Yeah, so if you think about platform, so if you think about Apple as a platform, Apple's good at coming up with cool ideas and marketing it. So if you take a multi-strategy fund, the platform owners have to be good at raising capital, obviously, because that's one of the biggest things you need. And then you have to be good at risk management and the operational infrastructure. So what they're providing in a sense, is providing all the stuff that's not investment-related to the underlying pods. So the pods can go about doing their investing, and then the platform provides all the other services.
Tracy (10:03):
So talk to us about what multi-strategy funds are actually doing here. Because I think about a traditional hedge fund, maybe something like Pershing under Bill Ackman, there's a charismatic guy, to put it one way, and he's making all these big bets. He's going long or short certain companies. Multi-strategy funds, obviously the clue is in the name, they have a bunch of different strategies – but typically what are they doing on a daily basis?
Krishna (10:32):
So I think there's a couple of reasons why they are in prominence, right? So the first and foremost one is that, of course, you have the regulatory burden of a single manager hedge fund has gone up dramatically. So if you are a single person and you want to start a hedge fund, it's much more complicated now than it was 20 years ago.
Tracy (10:52):
This is like the key man risk aspect of it?
Krishna (10:55):
Well, the key man risk, but also the operational infrastructure you need. And the reporting and all the other regulatory burdens that come with it, is tremendous. So that's one aspect of the thing a multi-strategy fund is solving. But the other thing is the multi-strategy fund is technically looking for good managers and providing them a platform so that they can actually run their business.
And the multi-strategy fund, the fund holding company, then provides all the other infrastructure needs, like risk management, reporting, all of that fun stuff. But if you think about why they have done so well in the recent past, I mean, part of it is just that we have this demand for leverage, right? In the system. So if you think about what we did in the global financial crisis, obviously in my view, the fiscal response was very timid, right? Like, we spent about 3% of GDP, compared to Covid where we spent 10% of GDP or more. So that meant that our recovery was very, very timid. And there was this whole thing with austerity, not just here, but elsewhere too, which meant that real yields collapsed and the overall return you could get on capital collapsed.
So the only way for you now to generate any sort of return was to take a lot of leverage. And so hedge funds as a whole are doing that. Like they provide you some form of leverage in terms of access. But the multi-strategy funds take it to the next level, where one of the biggest problems with a single manager fund is often that you may not have that many good ideas. So if I'm a macro guy, I'm probably lucky if I find four good ideas in a year, right? The rest of the time I don't know what to do. You know, I have to keep busy.
Now, if you're an investor paying 2 + 20 fees, you want all the capital to be deployed at all times and to be invested in all sorts of things. So one of the problems the multi-strategy fund solves is to make sure that capital is always deployed. And they do that by applying a lot of leverage. So a typical multi-strategy fund, you give them a dollar, they have $4 or $5 of exposure, and they have multiple pods that are then essentially deploying that capital.
Tracy (13:32):
My impression post-financial crisis was this idea that leverage was supposed to get more expensive, and it definitely did, I guess, for regulated banks. And we saw, for instance, the regulations on things like prop trading, I guess liquidity coverage ratios, just everything that makes it more difficult for banks to actually trade on behalf of their clients or for their own books. So how are multi-strategy firms getting the edge here, on leverage?
Krishna (14:02):
So leverage is always expensive. I mean, it was much cheaper 10 years ago, when interest rates were close to zero everywhere. So you could borrow infinite amounts of money. And so if you think about the performance of these strategies, they've been phenomenal in that period.
We need two things for a typical hedge fund or any sort of levered strategy to work, right? The assets you buy have to yield more than the cost of your funding. So if you go back in time, we had a positive upward sloping yield curve, which meant that you could borrow money at 1% and buy assets for 2%, 3%. And so you could lever that up, and then even when we had two-year notes here at half a percent, you could borrow money and buy two-year JGBs, FX-hedge it back and generate a 2% kind of quasi-risk-free return.
And so there were many similar sort of trades that you could do. Historically, that was what I think fueled the performance of these strategies, right? And now if you come to today, leverage is expensive. Most multi-strategy funds are probably funding themselves at SOFR plus some spread, so maybe 6%, and the coupons you can buy, they're all much lower because we have an inverted yield curve where SOFR is much higher than any sort of coupon you can buy. So a lot of the strategies that are carry type strategies don't work as well. But then you have all these other sort of quasi-RV type things where you're long and short different things, and those sort of strategies tend to do better in this environment.
Joe (15:38):
So in addition to, of course, all the infrastructure and all that, the importance of a strong risk management at the top, and I want to talk about that further because I can think of a couple of ways in which risk management might be expressed. One is obviously people get fired somewhat quickly for poor returns. If a manager's strategy or approach isn't working, they're not going to be held around for long.
I imagine another element too, is style drift and making sure that pods are actually investing in the way in which they're sort of mandated. If you want that diversification benefit, you don't want some random, let's say, or some quant strategy, whatever, to be like quietly really just going long Super Micro and Nvidia, or finding a way to just do a buy AI strategy because that's what's hot right now to juice return. So talk to us a little bit more about the risk management component in terms of allocating capital internally and making sure that the managers are actually not all crowded into the same trades.
Krishna (16:39):
So this is a super interesting topic, Joe, and I think this is the most important topic at the moment. So if you think about it, there's a conservation of risk, and it's just like conservation of energy, right? So you can't just get rid of risk, it just gets transformed and it gets passed around from one person to the other person. Because in a complex system that's what happens.
So if you think about what multi-strategies are doing in a sense is what the banks were doing 10, 15 years ago before the Volcker Rule and before Dodd-Frank came about, right? So if you had some off the run Treasuries and you know, somebody had to sell it, you took it down and you put it on your balance sheet. You know, when I started at Citibank 20 plus years ago, we had 20 people on the spot trading desk, and we had an auto trader machine, which worked some of the time, but then when something happened, some sort of event happened, the machine would not be able to do it and it would get passed to the humans that were on the desk.
Now you go to Citibank, you'd be hard pressed to find maybe three spot traders, and the machines basically have taken over, right? So all of those people that were there, they've all moved to the multi-strategy funds, right? So the typical multi-strategy fund has specific pods that are focused on trading one particular asset. So in many cases, you'd have a trader, he would only trade five year notes, and that's all he's doing, that's all his mandate will allow him to do.
And so what this does from a systemic point of view, is, we've shifted all the risks that were on the bank's balance sheet onto these funds. Which is great, I mean, which is not a bad thing, but if you think about how the capital is now managed, we are very good at coming up with complex formulas to calculate risk, and do all that. And we saw that with the VaR issues in the past. We had the Black Monday episode with the CPPI (constant proportion portfolio insurance), which turned out to be a bad idea. And then we also saw it with the CDO crisis where we had this single correlation pattern. We were using the models and it wasn't capturing the real dynamics in the underlying portfolio, right?
So we've always had this issue with creating these mousetraps to manage risk, and often they create other problems, right? So I think one of the issues now with the growth in the multi-strat universe and the fact that they are fairly large, is if you have a stat-arb book and you are running a 50 by 50 stat-arb book and something happens, or you decide like you want to de-risk, it's fairly easy. You could probably get out the whole book in no time.
But let's say you are a $40 billion fund that now has levered that capital up four or five times, and now something happens and you need to de-risk, there is no other side for that trade. There's no balance sheet on the other side. And we saw that in March of 2020, people had all these basis trades, because if you think about it, when you don't have carry, when you don't have an upward sloping yield curve, a lot of the traits tend to be this sort of fixed income RV type stuff where we are doing this basis stuff.
And many of those basis trades started to blow up in March of 2020, and then the Fed literally had to intervene. So we have this sort of thing where the size of the overall funds is so big, we have about 400 billion at the moment, and they're growing at 10, 15% a year. And you take that and you multiply by three to get the actual dollars invested. So there's about a trillion two dollars in these platforms, and they're all risk managed the same way. And I think that is the problem we could have.
Joe (20:27):
Outside, though, of the big event, whether it's like a Black Monday day or whether it's March, 2020, with relative value in normal times, just how would you describe the sort of day-to-day blocking and tackling of good risk management, of evaluating pods?
Tracy (20:44):
Just to add to that, I'm really curious, so multi-strategy funds, it's a collection of different strategies, obviously. So how are risk managers getting a sort of holistic view of that business? And then also I'm super curious if they're all using the same software. Like I remember writing about BlackRock's Aladdin and the portfolio management tool there almost a decade ago now, but I'm curious, is everyone using the same sort of system to do this?
Krishna (21:11):
Well, I don't know about all of them, but you know, I can say that the risk thinking is kind of similar in a lot of these firms in the sense that, imagine you had a dollar and you levered it up to $4. Now you want to make sure, let's say you promised your LPs that you're not going to lose more than 10%. You know, you want to manage each of the underlying strategies that you've deployed capital into, to not lose more than 3%, right? Because then by definition, if all of them lose at the same time, you've now blown through your 10% limit.
So that means that they all end up with some sort of risk management that is not necessarily bad when you look at the platform as a whole, but from the perspective of what it does on a systemic basis, it's not great. So I know Joe mentioned this thing about the basis blowing up in March of 2020, but you have this episode every other month where you could have some random event, which has nothing of any real significance, that could cause a little unwind of positions, right?
So what I mean by that is, so let's say you're going into the Polish elections last year in September, you look at Polish rates and Euro-Poland, the currency, all kind of started to move in the wrong direction, meaning Polish rates blew up and Euro-Poland started to rally. And part of the issue there is that when you have a whole bunch of strategies that are all risk managed the same way, it's no longer about the fundamentals, right? If the P&L starts to move in a certain direction, you now have to de-risk your book and that causes these events.
Joe (22:53):
Well, this is what, what I really want to get at, because I want to talk about – you can see the chart of EURPLN and it shoots up and then a month later it's back to where it was. What is that day-to-day risk management process that causes trades to all go in one direction like that? Again, like outside of crazy times where it's like a pandemic hit, day to day, if I'm a manager at a pod shop and I have the platform over me evaluating my risk, talk to us about that process and how that informs the risks I'm willing to take.
Krishna (23:26):
Yes. The risk management is almost algorithmic, right? So it's not even, because it'd be very hard for the risk manager at some massive part to know every individual position. So they kind of understand the whole thing, but they don't necessarily know [what X or Y is.] So essentially what happens is your P&L kind of drives risk management, right? So if you draw down capital, you know you're getting de-levered, right? And not only are you getting de-levered, let's take Poland – it's a good example – and we have a position in Poland, so we kind of follow it closely. So imagine now you're at a pod and now you have a Euro-Poland position, now you have to take it off because you know it's gone against you.
And if you lose more than 3%, your capital is going to get cut in half and you lose 5%, 6%, you're probably getting stopped out, right? So that's typically how the pod capital gets allocated. So now you are de-risking that Euro-Poland position, which then causes everybody else to also de-risk as well. So it's not even like a risk management thing, it's just the structure where everybody is allocating capital in the same way, which means that an innocuous thing, like somebody literally coughing at some place, causes something to move, and then next thing you know, a whole bunch of people have to unwind the positions.
Joe (24:53):
So diversification in investing is generally good and people like it. And one way you can diversify is over time. So it’s like, in theory it's like people buy the S&P every two weeks in their 401(k) or something like that. But it sounds like in your example is that the pod manager does not have the ability to diversify with time, that as soon as the move goes against them, they don't really have the luxury to say ‘Yeah, well, it's just a brief thing and it'll be back to normal.’ They can't let the position lose for very long.
Krishna (25:27):
Yeah, I think so. And also the other aspect of that which you touched upon is the fact that you're not maximizing long-term returns. You're maximizing returns per unit of time, right? So what what it means is, let's take a different example, let's say you have a stock, so any given stock on any random day is just some beta to the S&P, right? It's just going to move along with the rest of the market unless there's some stock specific news. It's just going to keep up with that, except that when you get into an event like you have a earnings release or Apple's Vision Pro is getting released at that time, now there is actually an event, and now you have to take a view on whether it's going to go up or down at that point in time.
So what happens with this sort of pod capital and that being a bigger part of the market is that you now have to basically take a view on this event, which is an earnings release. Now, if it turns out that all the pods think that the earnings are going to be good, and if the earnings actually is not good, now we know that the stock is going to have a massive reaction because everybody will try to get out at the first possible time, right? So you create these sort of mini crashes in equities and in other markets because of the way risk is managed.
Imagine if I were to sort of look at my position every day and say on every little blip ‘I'm going to take all my risk down and not only take my risk down, but take other positions I might have, also down,’ that's going to cause these sort of systemic events, which I think is actually an opportunity. If you are not playing that game and you're playing a slightly longer-term game, then it's a great opportunity.
Tracy (27:28):
So just to hammer this point home, in addition to the sort of short-termism that you just described, there's a sort of reflexivity that's happening here too, where if a position starts to trade against you and everyone gets out at the same time, that makes it worse. But also if a position is going in your favor, then everyone crowds in and that gives it momentum and it sort of exacerbates the up crashes, as Joe would say.
Krishna (27:55):
Yeah, I think to some extent that is probably the case, but I would say we probably have the ETFs to blame for that. Just because of the way the ETF market is, and a lot of what is happening now is money flowing into ETFs, which then end up buying whatever is the underlying index of stocks. And then you end up with these stocks that don't have a lot of free float.
So you have large inflows. I mean, and this is not just a US phenomena, like you look at what happened in Europe year to date, right? The top five six stocks in market cap are up like 15%, right? And the same thing in Korea, same thing now. So everywhere in the world, as more money flows into these passive vehicles, I think it generates this effect where people are just buying it without actually looking at the valuation.
So take Nvidia – as long as we have new money coming into the S&P 500 then Nvidia stocks are going to go up, and until something happens, as earnings come out or something else changes, this thing sort of drives the momentum effect. The pods I think have a little bit to do with it, but I would imagine the typical long-short equity pod is sector neutral and market neutral and all kinds of neutral. So basically they try to neutralize every possible factor that they could lose money against, right? And so that's what they do.
I actually think that there might be a new factor that we might have to have, which is the multi-fact, multi-strategy pod factor. Because this is a factor, like if you have a stock in which a lot of multi-strategy pods have a position, that might make that stock behave differently.
Joe (29:38):
By the way, Super Micro, I think it was up about six, what did I say? It was up about $60 on the day when we started the episode. It's up $80, $81 now. So when we see these crazy moves on the upside, it's like, okay, there isn't much free float. There's this sort of like uninformed demand from the ETF flows. And then when we see like the crazy moves on the down, it's a lot of pod managers all with the same risk profiles. How quickly do they get fired? Like, in my mind they're like, oh, they have a bad few weeks or a bad quarter. What is the reality of like longevity and how quickly do they just say ‘You're not cutting it?’
Krishna (30:12):
You know, my guess, and this is not scientific – it's not very long. But you would be surprised that a lot of these fairly large platforms have managers that have been around forever, right? And they all have something in common. One of the things is if you have a very high Sharpe ratio strategy, so a strategy where your volatility is small relative to your returns, then you're more likely to survive in this sort of hard environment. Because if your drawdowns are limited, and then every once in a while you might have a big blow up, but then that's just part of the high Sharpe ratio game, right?
So there's a very nice paper by Jean-Philippe Bouchaud that shows that most of these high Sharpe ratio strategies often tend to have negative skew, the P&L profile, which kind of makes sense. Like if you are going to sell S&P options every day, that's going to be a very high Sharpe ratio strategy until something happens and then you lose three, four years worth of P&L, right?
So I think the longevity of a typical pod is not that high, but you'd be surprised how many of these managers have done extremely well over time because they have these sort of high Sharpe ratio strategies that they can then survive.
Tracy (31:34):
Some of this reminds me of the original discussion, like I guess it would've been more than 10 years ago now, but around algorithmic or machine learning trading, where like the big discussion point was, okay, you get a news release that comes out, maybe it's something company specific, maybe it's something macro, like the latest jobs release, and all the machines react to it. Sometimes, or at least back then, they would pull back from the market and just wait a little bit. But the idea was that you kind of get this gap where if you're not a machine or an algorithm, maybe there's an opportunity there in the market. Maybe you can be smarter, I guess, than the machines that are sort of like going on rote code.
Krishna (32:20):
Yeah, I think if you think about it, the biggest opportunities for slightly longer term investors – so if you are, let's say your time horizon is not a month or three months, now this gives you a great opportunity because you obviously get these big drawdowns every few months, right? So, in my personal view, I think we have some active ETFs that we think of as longer-term capital. And we're looking at creating some sort of a drawdown structure where we actually wait for these big drawdowns that are caused by the pods and then use that to actually participate in these moves.
And then, that again could be a very interesting way to take advantage of this stuff. But anytime you have an algorithm that decides how capital gets allocated and it's sort of rules-based, you kind of know that it's going to create a problem, in the end, because the market is sort of a complex machine. So anytime you think you've found some risk mousetrap it's probably going to create other issues elsewhere.
Tracy (33:24):
This might be a simplistic question, but how do you measure drawdowns? How do you know that those are happening and impacting a particular stock or a factor?
Krishna (33:32):
So you can kind of look at that on a micro scale by certain specific assets that are in focus. So for instance, let's say you're going into an earnings release and you sort of see that the stock missed earnings and then has a massive reaction and it's a several sigma move. And you'd sort of say like, ‘Okay, the company didn’t miss earnings this quarter, but otherwise everything else seems to be fine. It shouldn't be as big a reaction.’ And you can kind of look at these reactions from the past when they've missed earnings, and you'd find that the reactions are much larger now. And part of that has to do with the fact that a lot of the capital that is deployed – apart from the ETFs, which are passive holders of this stuff – the active management part of it is a lot of these pods and multi-strategy funds.
And that creates this kind of behavior not just in equities but in other assets as well. Like, you might get a really massive reaction in Treasuries for some random thing, and you'd be like, ‘What has changed?’ The economy hasn't really changed that much, but because everybody was one way, now they all have to kind of get out of the way.
This also applies to reactions like the CPI. I mean, we had a big repricing in the front end, which kind of made sense, but when you look at the Treasury move, you say, ‘Ah, does it really make a big difference in the grand scheme of things?’ The one-year forward 10-year yields and the five-year yields are about the same, they're about 4%. So that hasn't really changed, but people's positions had to be unwound, and that creates these sort of large reactions.
Tracy (35:14):
So, one thing I was wondering, just going back to why these types of investment firms seem to have proliferated in recent years. I mean, to some extent, this was the desired outcome of post-2008 regulation. Again, you make it more expensive to get leverage if you're a bank. If you're a bank, you also can't trade for your own account anymore. And so it all shifts into — I kind of hate this term nowadays — but this is the shadow banking system, and it gets done there.
So I guess my question is, how worried should we be about this activity on a systemic basis? And then secondly, could multi-strategy pod shops be hit if we were to see leverage get more expensive? For instance, there's a lot of talk right now about the basis trade in Treasuries, and maybe regulators are going to start cracking down on that or making it more expensive to use Treasury futures, which are basically a source of leverage in that market. Is that a risk here?
Krishna (36:19):
I think on the second question, there's definitely a risk that the cost of leverage goes up from a systemic point of view. If banks are financing these trades, and if that financing business gets charged more in risk capital, then you would imagine that the traction of some of the pods becomes less attractive. Because if I have to fund my book at 10% when risk-free rates are 5%, then I'm less likely to find good opportunities. I mean, I'm still going to find something, but not as much of this RV-type stuff.
But the other aspect of it is like what they're really serving, you know, I think, which is like one of the positives of the multi-strategy funds is that, unlike a fund of funds where you couldn't net risks together, here you're able to net all this exposure. Imagine you have one person long on Tesla and the other person short on Tesla. Now you, as the end investor, don't have to have these two positions in two different hedge funds. They're all getting netted, and you're only getting charged for the net exposure.
Tracy (37:28):
Cross-margining, basically.
Krishna (37:30):
Cross-margining, which has been a big challenge. So if you are a single-manager fund, and let's say you're invested in like 10 different single-manager funds, what if like five of them are long on Tesla and the other five are short? Now your problem is, you’re on a net basis, it's kind of flat. You're paying for everyone's leverage. And so that is a big advantage, I think, of having this sort of thing.
But on the flip side, if you think about it, imagine you have five pods that are long on Tesla and five pods that are short on Tesla, just to take a simple example, and Tesla goes up. Now, a typical multi-strategy investor takes all the netting risk. So historically in a hedge fund, if you invested in a hedge fund and the hedge fund didn't make money, you didn't pay any fees to the manager. But now, with the pod structure and the multi-strategy platform, the people who made the money are getting their payouts, and then the ones that lost money, now you're actually taking the losses. So if you have too much dispersion, that's not necessarily good from an overall perspective.
Tracy (38:39):
And what about the systemic aspects of all of this? So yes, okay, there are some weird moves in the market, and maybe there's more short-termism, and we're getting bigger reactions to one-off events or announcements. But is it an issue that we should be worried about? Should regulators be thinking about this?
Krishna (38:57):
Well, I think the issue is less to do with the day-to-day stuff. It's more to do with these events, right? So I think the risk becomes more material when you go into any sort of event that we are not thinking about. Like, for instance, let's say an EMP strike happens and all the grid goes—obviously, we would be thinking about other things at that point, but it is just to make an example of something that we're not thinking about. If that were to happen, we could have big systemic unwinds of positions just because of the way risk is managed, right? And this is just natural. If you have a system where there's a lot of leverage and it's being tightly risk managed, you are going to create these unwinds over time.
Joe (39:40):
I'm curious about the non-systemic risks to the model. And by that I mean like there have been a lot of new hedge fund launches over the last several months. I keep seeing headlines on the Bloomberg, many of them with the multi-strat model. I imagine many people at multi-strategy hedge funds want to be the guy on top rather than the pod, with the, always having to worry about – is their capital being pulled so they leave and start something new.
The returns for several of the existing ones are pretty extraordinary. Last year, I think Citadel's the Wellington fund, was up over 15%, like a really pretty solid year. Setting aside systemic events, is there a risk that just like the strategy is no longer as good, the more people go into it? Because typically that's how it is. You just think about with investing; various quant strategies eventually don't work when everyone figures out the abnormality or whatever. What do you think about like the long-term prospects of good returns in this space as more people try to do the same thing?
Krishna (40:36):
I think it's a great question. So I think the smaller you are, the better your advantage is. Because, you know, if you go back to what I was saying before, if you have a hundred by a hundred long-short equity book, you could get out of it immediately, right? If you have a fairly large book, it's nearly impossible to get out. There's no exit liquidity for the trades, right?
So the size is a major factor in terms of how they would perform over time. Now, what does happen is, the larger funds tend to have better financing terms, because they've been around longer, and so they've locked up all the funding, and you know, so that there is a definite benefit for the size. But from a forward-looking return basis, you're going to be much better served in smaller multi-strategy funds. Because multi-strategy as a concept is not a bad idea, it's just that the size has become so big.
And also think about how these managers are moving around, right? So imagine somebody had a great alpha source, some secret sauce, and they worked at a fund, and now their junior person moved to the fund across the street and starts to do the same thing. Now essentially, that's what's happening, is most of these strategies, the alpha is kind of decaying, right? Because you have all this migration of people.
So you might say you have 50 or 40 multi-strategy funds, but they might all be doing something very similar, right? And so that, I think, is going to mean that overall returns might not be as attractive as they have been in the past. I mean, and some of the multi-strategy funds have been spectacular, right? Like you look at Citadel that you mentioned; they've been phenomenal.
Joe (42:14):
Millennium had another good year last year.
Krishna (42:16):
They've been great. I mean, so in the past, they've been phenomenal. But on a going forward basis, as this thing gets bigger and bigger, you would imagine that the alpha kind of comes down. You don't have as many people. So if you take a typical multi-strategy fund, the person who starts out starts out with 2, 300 million to manage. So if you have a trillion two of capital, you're going to need 40,000 different pods. I mean, not every pod is that size. A lot of pods are much bigger, but you know, you can just think about the number of people that you're going to require and enough orthogonal strategies. And I just don't think there’s that many orthogonal strategies out there.
Tracy (42:55):
So this might be getting ahead of ourselves a little bit, but we started out describing the evolution of hedge funds. So going from the 2+20 model to fund of funds and then multi-strategy, what's next in the evolution? If there is a risk of overcrowding and alpha decay as you just described, what's the next big thing on the radar?
Krishna (43:16):
So I think this will evolve; it'll take time obviously because you'll need a few years of underperformance before people say like ‘Oh, this doesn't work.’ But in my mind, the two things I'm betting on is one is obviously anything that takes advantage of this sort of behavior, right? Where you are being risk managed and forced to unwind positions. So if you can actually have slightly longer-term capital, you can actually be the person going and buying the stuff when everybody has to sell, right? So that's a bigger opportunity, I think.
And then the other one is any sort of long-term capital structure, like an ETF or any of that sort of stuff. Because what happens there is that an ETF investor is not looking at it every single day. I mean, although some might be, but most of them are investing for the long term. So, if you could sort of manage that sort of money, then you get the ability to actually sit through all these things.
Joe (44:10):
Krishna Kumar, Goose Hollow Capital, thank you so much for coming on Odd Lots.
Tracy (44:14):
That was so good. Thank you.
Krishna (44:16):
Thanks guys.
Joe (44:29):
Tracy, I really enjoyed that conversation. There was a lot in there that was interesting to me. I think where I would start was actually maybe with that last answer where it sort of seems like, you know, the one thing that a pod seemingly cannot do is just that sort of like long buy and hold philosophy, right? That's the one sort of bread and butter investment strategy that you probably can't do when you're being short-term managed like that. So in the end, the benefits may accrue to those who can just, and it's like what every financial advisor says, ‘buy the index and go about the rest of your life.’
Tracy (45:01):
Stocks go up in the long run? Yeah, absolutely. That really crystallized that point, the idea of it's the time horizon that is different here. And also the crowding behavior. I was sort of thinking back, do you remember flows before pros?
Joe (45:17):
Yeah. That's your line.
Tracy (45:17):
Yeah. So the idea there was that okay, in an environment of low returns, sort of post 2008, that it's hard to find genuine outperformance. And so the best thing to do is just follow the crowd and that's how you kind of eke out alpha. And then I'm thinking about it in the context of the multi-strategy firms, and I'm kind of thinking like, maybe pros create flows now? Maybe that's what the multi-strategy firms are doing. Like they're just going in and out on a daily basis.
Joe (45:46):
Yeah, it's exactly that. Like I knew that there was a lot of trading volume that came from that, but I don't think I totally understood why they had to trade so much. It's like why not just invest in some tech stocks and they'd probably go up, but if you think it’s like, no, you're really like not being paid to just take a long-term view or anything, because the long term is for the end investors, the long term is for the LPs and everyone else.
Your job is short-term performance and you sort of like diversify it that way and it benefits the long term. There's just a lot of interesting things about the isolating aspects. It also makes so much sense about the capital efficiency of pod shops versus the fund of funds which no one enjoys. All these things sort of make a lot of sense to me now.
Tracy (46:28):
Yeah. The other thing I would call out is the leverage point. And again, this has been going on for sort of a long time and again, I would call back to the lack of returns in the post-2008 environment. That's when we saw people start to use a whole host of — well, not start — but using a whole host of interesting derivatives, like CDX index options to bet on corporate credit because you had that general macro environment as well. Things are sort of evolving now, but I take the point, okay, leverage is expensive, particularly if you're a bank. And that's part of the reason we've seen it migrate in some respects to multi-strategy funds. But I am interested to see if that kind of war, the regulatory war on leverage starts to pick up because we have seen, again, going back to the basis trade and Treasury futures, a lot of noises about that. And so yeah, definitely something to keep an eye on.
Joe (47:22):
Yeah, there's a lot there. Also just that point about like, okay it used to be that the sort of proprietary trader at the bank could take advantage of some weird dislocation when an investor needs to sell some off the run Treasuries and there may not be an obvious buyer for at the moment and you like pocket a little bit of money. And how–
Tracy (47:42):
Yeah, that balance sheet that was available...
Joe (47:44):
Yeah, for those types of trades and how that creates opportunities for these funds and the specialists in these areas to identify those. Anyway, really interesting conversation.
Tracy (47:52):
So much in there. Shall we leave it there for now?
Joe (47:54):
Let's leave it there.