Why Asset Allocators Love Multi-Strategy Hedge Funds
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Hello and welcome to another episode of the All Thoughts Podcast. I'm Traci Allaway. And I'm Joe Weisenthal. Joe, did you at some point last month when markets were being very, very dramatic, did you maybe hear that a pod was blowing up?

Maybe, just maybe. I probably saw some tweets, probably tongue in cheek. I may have sent some DMs to people saying, jokingly, have you heard of any pods blowing up? But no, it's become such a meme anytime the market moves half a percent. I imagine some pods did blow up.

But it is a funny joke. Good intro. It's definitely become a thing. But I think it kind of highlights something very real, which is there is this mystique around pod shops, the multi-strategy hedge funds. And whenever something weird is happening in markets now, they tend to get blamed or people start joking about them.

And also part of the mystique is there's just a lot of interest in why they seem to be so hot right now, blowing up in a very different way. And what exactly is the attraction for big allocators of capital? Because I always think it's not like big investors can't create their own diversified portfolios or invest in a fund of funds or traditional two and 20 or whatever. So what exactly is it about the

pod shops that makes them so attractive. We've done a lot of episodes on the multi strats at this point, the pod shops of various flavors. There are still a lot of things I don't understand. First of all, my understanding is that they sort of continue to prove their metal. I mean, it seems like they didn't lose a lot of money in April during some of that volatility. So they have this promise that,

uncorrelated returns, and we'll get into how they deliver that. So far, it seems like they continue to more or less do what's advertised. I have a lot of questions about how and what is the actual source of alpha and how long can this go on and whether there are a lot of copycats and whether that will cause alpha decay and all this stuff.

I have questions about comp, the most important thing. Well, this is really important. And actually, you know, we did that episode with the founder of Freestone Grove, Dan Morello. A lot of the conversation was about comp. And I'm interested in comp because I'm interested in the topic of making a lot of money. But also, I get the impression that comp and incentive alignment more broadly is actually one of the key problems that

that people are trying to solve for all the time. I think that's right. Okay. So I am very pleased to say we do in fact have the perfect guest. We're going to be speaking with Ronan Cosgrave. He is a partner at Alborne Partners. So Ronan, thank you so much for coming on All Thoughts. Thank you very much. I'm really honored to be here. First question, what exactly is Alborne Partners? Because it's not a pod shop itself.

No, no. So I co-lead multi-strategy hedge fund coverage at Alborn. We're an advisory only, independently owned consultant. We help institutional investors invest in hedge funds, private equity, real estate, all across the alternative asset spectrum.

We have about 350 clients worldwide, and we advise on greater than $750 billion in assets. Okay. Give us a little bit more of your background. You're the perfect guest to talk about multi-strategy hedge funds and why allocators like allocating to them. Talk to us about how you built up your familiarity with the space and how you've built up your understanding of their inner mechanics.

That's a long answer. I've been over 20 years in the hedge fund industry. I worked at a fund of funds called Pamco for 15 years as a partner there. Did a whole lot of stuff there, covered pretty much kind of the constituent strategies of many of the multi-strats, right? You're talking about long-short equity, long-short credit, convert ARB, vol ARB. As it got more difficult, I got more involved. Since then, I've worked with Alborne. I joined Alborne four and a bit years ago.

And, you know, with my colleague Martina, we cover the multi-strategy universe globally. So part of our job really is to kind of

Dig in deep into the multistrats, not just learn about the people, but the process, the inner mechanisms of what differentiates one particular multistrat from another. And the really cool thing is that they're all actually really different, you know. And one of the fun things listening to you guys is when you talk about pod shops and so on and so forth or multistrats in general. I mean, there's huge differences in how they're run internally. Yeah. You know, and the other thing I distinguish is.

in the multi-strategy space is the pod shops, which are the classic ones that are, you know, with the three layers of fees versus the more traditional multi-strategy hedge funds, which are two and 20.

Oh, that is an important difference, isn't it? Before we get into that, I want to ask, when you're doing due diligence on possible hedge fund investments, how do you go about doing that, actually? Because you just said you dig into, you know, the culture, the people, risk management. How much access do you have and how do you do that? That's another big question. So the thing is with the multi-strategy hedge fund space is you start investing

really with the single strategy stuff. And it's not really fair to ask anybody to cover multi-strategies if they haven't worked hard at understanding the individual contributions of all the different trades and trade types that make up a multi-strategy. But the critical thing, and you alluded to this, is that multi-strategy hedge funds are another level of abstraction away from the markets. Because yes, we do look at trades and traders and PMs and stuff like that, but

almost as important as you're evaluating them as business models. You're evaluating them as risk models and investment models. And, you know, they're all super interlinked. And one of the things that we look at and look for is kind of consistency between all the strands. Because if you have things that are in conflict internally, you end up with a suboptimal outcome, right? I mean, we've all lived that in our own personal and professional lives.

But if things aren't in alignment, and you mentioned compensation, compensation is a huge part of that. And I'm, you know, one of the things I'd argue is that comp affects far, far, far more dimensions of a multi-strategy hedge fund than almost any aspect. Yeah. No, this seems very interesting to me because often it feels as though, okay, you have some investment strategy and then,

make a lot of money. And then, okay, some of it goes to the manager and some of it goes to the outside investor. That's how I conceive of things. But it really does seem like comp structure is actually core to the business model. But before we get to that, why don't you actually go back for listeners and for my sake, when you distinguish between the sort of traditional two and 20 multi-strats with the so-called pod shops,

which in my mind I associate with the millenniums of the world. But talk to us about the differences in these business models when you use these terms. Yeah. So when I refer to 2 and 20, simple, it's a straight management fee of 2%, but it could be any fixed number. Yeah. And a performance fee of 20% on the overall portfolio. So the only fees paid by the investor are the management fee, which is designated in advance.

plus a cut of the gross performance of the portfolio as a whole. And that's a really critical distinction between them and the platforms or pod shops, right? So a pod shop has all that, right? Now, first off, the first thing that happens is that the management fee may or may not be fixed. It can be what's known as a pass-through fee, where it's kind of a blank check in many ways. For the most part, they do take good care of that. But the third layer of fees that's really important is that there's fees payable

at the level of the PM, not at the overall fund. And when you get to that level, there's a lot of things that people take for granted in investing just simply break down. And to go on to that, the one thing that I keep getting told in my own personal investing life and everybody's personal investing life is that diversification is the only fee lunch. When you are paying performance fees,

on individual components of a portfolio, diversification is not a free lunch. It costs you money, real money.

Wait, can you explain how do clients, how do investors actually pay individual PMs? Like, how does that work? Yeah. So in a pod shop, what you have, you think about it is you have, you know, a number of PMs, anything between five to 300 and something. They each basically have their own individual P&L, right? So they, the manager, the overall fund manager tracks each PM and their P&L.

They'll charge back all the appropriate stuff that would normally be charged. Bloomberg, for example, all of the trading costs, the analyst costs perhaps. And then if that number is above zero, the PM gets a payment from the manager out of the fund. And that's their performance fee. So the investors themselves don't actually pay them. It's paid for them by the manager.

Now, you said that there can be instances in when diversification is not a free lunch. And so I take that to mean that you can have situations in which at the fund level, you don't have a good year and you're not making any money. But some pod managers had a great year and they still have to get paid. And so you talk to us a little bit about these conditions under which diversification

that diversification can be costly. Yeah, let's use a simple, simple model. So you have a pod shop, but you only got two pods. And at the end of the year, one pod is up $10 and one pod is down $10. Because it's a pod shop, you're paying on the P&L of each individual PM. So let's say it's 20%, right? So on a gross before fees basis, you're flat. However, you're paying the guy who was up $10, $2.

Right. So after this is added together, now your portfolio is down $2 and that is netting risk. And the interesting thing about netting risk is because to bring it out further is that netting risk, you could argue, well, that shouldn't be an issue for the ones that pay at the top level. Well, the issue is that because they exist in a competitive landscape for PMs,

Pod shops can go to a PM who didn't get paid. Oh, I see. So if you think about it, if that was a traditional two and 20 multi-strat, $10 up, $10 down flat, nobody gets paid. The fact is you've got a very, very unhappy PM who's up $10, who's made $10, who's like sitting there in the corner, really angry because they worked really hard, they made a lot of money and they get nothing.

And the pod shop can ring them up and says, we'll take you. Yeah. You know, I will guarantee if you make money, you will get paid. Got it. The other thing to remember as regards netting risk is it's actually, we've modeled it at Alborn. We've worked it out and using various simulations. It averages for a, just a regular set of managers and PMs at around 1% a year.

When you think about a 2 in 20 hedge fund, you kind of expectationally should expect to pay 1% of that 2% management fee to people who've made money when everybody else has lost money. And it can be way more than that. And that's a real business risk. And here we have a specimen from the early 2000s, a legacy investing platform.

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So one thing I wanted to ask is I get the impression that pod shops are very, very competitive.

And, you know, the talent is competitive, but the pod shop itself is supposed to kind of work together, right? And the positions are supposed to diversify and even each other out and all of that. So I guess my question is, how cutthroat is it actually working at a pod shop? It varies. The fact is that a pod shop is an entity that can make certain decisions to create either competition or cooperation. Any multistrat can do this.

In a pure eat what you kill environment, obviously there's no incentive to do cooperation, but people do recognize this, right? And what I would say for that is,

That it's all about what do you want as what does the manager want to produce? And one of the things what I would say is there's a real choice that you have to make between kind of talent and structure. And what do I mean by that? What I mean by that is to use a sports context. There's kind of two ways to assemble professional sports team. The first is get a big pile of cash and go hire the best players in each position and put them on the field and hope for the best.

Right. That's a focus on talent. The other way is to hire a really, really good coach with a really good system and to have him or her go with their team, kind of a money ball system where you put together people who fit in a structure. And what that means is the first one is like the emphasis on the individual. And the second one is the emphasis is on the whole.

And when you talk about competition, one of the main ways you enforce competition is quite obviously compensation. If you have a situation where it's pure eat what you kill and you get presented with your own P&L and that's it, it's very, very hard to enforce that level of, that's where you get those cutthroat stories, right? But there are many others out there who have other ways of doing this, who recognize that, you know, if you just have everybody in it for themselves,

You produce a portfolio that's actually suboptimal at the top level. This is what I was going to ask. Have you noticed a difference in performance between the sort of cutthroat competitive firms versus the more cooperative ones? That's a really good question. And the short answer is it's really hard to distinguish between them on the outside. The interesting thing really is more around what happens when things are going badly for both, that you're more likely to have people kind of like quickly leave the more competitive and cutthroat one. Ah.

Then you would have, then maybe they're more cooperative. You know, I mean, the cool thing about the pod shop and the platform space is there's literally no right way to do this. There's a real series of trade-offs, right? And there's choices you make across many different dimensions because, for example, if you choose to do cooperation, right, and you incentivize everybody, you typically would do it in a kind of a traditional multi-strategy context, right? What that means is that you're not going to have the eat what you kill mentality. You may have certain strategies

you know, bits around that. But if you use that thing, you have a very good place to work. But you end up with a situation where, as we talked about earlier, netting risk is a real cost. What that often means is that compensation choice

drives you to be a bit more correlated within your own portfolio and be a bit less, a bit lower Sharpe ratio. Why is that? Because if netting risk or the cost of netting is a real business risk, you choose to minimize it. And the way easily to minimize it is to have everybody kind of make money at the same time. Everybody kind of lose money at the same time. And then you won't be picked off by the pot shops. You know, similarly, if you have competition, right? Competition is an incredibly powerful human force.

But it gets out of control and you end up with a situation where people just burn out and just leave you. People are unhappy. You know, you have to kind of keep feeding people into it. And, you know, that's totally fine because there are many other industries out there besides finance that does this, you know. But at the same time, you know, you end up with a whole lot of scenarios that are kind of you end up with a kind of a team of rivals, you know, and then that's a it's a dynamic. But it's one you have to really control. Zooming out.

Obviously, the performance of a lot of the well-known names has done really well. You're talking to institutional allocators. Other than, I guess, the fact that the top line performance is good and everyone likes making money, what is the general pitch? And we've seen this trend, obviously, from allocation to single fund managers, you know, your traditional guys who would like go on TV and they unveil their long or whatever. Yeah.

As a digression, I always think it's funny when you see these pod managers on TV and they get asked about their thoughts about the market because it's clearly that's not really even what their focus is on in terms of business structure design. So I'm always sort of

raise an eyebrow when I see these conversations. Talk to us about what it is about these entities in general that hold so much an appeal for an institutional allocator. They hold appeal for a variety of different reasons, and obviously it will depend on the individual mandate of the allocator. But there's a couple of fundamental things that really hold true across all multistrats. The first one is that

It's interesting that we talk about pods like they're something new. But if you actually, if all three of us decided to go out and invest into 20 individual hedge funds, we'd have the same issue. A, they would be paid on what they eat, what they kill. B, we would have to hire and fire people. By the way, hiring and firing people, hiring is fun, firing sucks. But the point, but the overall thing is that each individual PM in that set of single strategy hedge funds is allocating according to what two things.

what they think their set of investors want and B, what they're willing to bear because it's their only job and their name above the door. And so what you end up is, is you have a set of allocations that when you roll them up together are individually way under risk. Right? And you're not making as much money as you should given the talent that you're paying for and the amount of fees you're paying. Oh, I see. So when you hire a multistrat and part of the thesis of multistrat, which is true, is that because they're a unitary portfolio with somebody at top,

in charge of it, driving the risk of the individual PMs, not the individual PMs themselves. You can, and really should, end up with a better return stream because you've coalesced all together under a single unitary authority and they can put them to, you know, they put leverage to work, risk to work, so that the

The individual PM might be more risky than they really, really want to be, or maybe it's probably obscured from them usually. But at the end of the day, that rolls up into an appropriately risked portfolio return. Right. And, you know, having somebody who worked in fund to funds, one of the issues of fund to funds is just that you had fantastic sharp ratios, but the returns were low. Hmm.

That's a really important point. One other thing I wanted to ask just on the why allocators are interested in multi-strats point. One thing you sometimes hear is that, well, multi-strats or pod shops, they can dip in and out of positions really, really fast and they can react to the market very, very quickly. How true is that?

So let's go back to two and 20 funds versus pod shops because it's differently true for both of them. Let's talk about pod shops first, right? In the kind of the stylized pod shop, you get a set up, you get money, you invest as a PM and you get paid on that. If you get cut, if your capital gets cut substantially, even with the best will in the world and the promises from above saying it'll come back to you, your pay has been cut. And I mean, we're all professionals here. If your pay is cut by 50%,

You're updating your CV and you're checking the job market. Okay. So in the context of responding to opportunities in the market, it's hard to move too much too quickly in the context of a pod shop. Why? Because of that reason. And B, because that person may not be there to do when it's an opportunity there. So it's kind of hard.

They do do it. They absolutely do do it. They will lever up into opportunity. But when you think about what people's kind of perception in their heads of what it is, it's completely more static than you'd imagine. In the context of a traditional fee structure, the two and 20, it's different, right? Everybody's incentivized to get the top line to be the highest number it can be. And so if I'm a convert manager and you're a merger manager, I'm cool with

with my capital being given away, I assume I get it back eventually. Oh, I see. But if it makes the overall pie larger, I can benefit in the long run too. I see. So the ability and then quite frankly, the willingness to move capital in size around is really, that's where comp comes in. Comp has now led us to the situation where it's hard to move capital, right? And you think about, I'm going to talk about kind of the theme of this for me is,

Comp kind of drives everything. How you structure your comp is one of the principal underlying features around how multi-strategies work. I think this is such an important point because, again, I think like...

Like comp structure, you hear about it. Like people love reading stories about bonuses, et cetera. And people love reading stories about people getting paid a lot of money or maybe they hate read those stories about people love getting maybe. But this idea that, no, this is the business. You know, people, I think when people hear bonuses, they're like, oh, you get some extra money. But the business is designed. I mean, to hear you describe it.

The business is the design of the bonus. The business is the design of the comp. It kind of is, you know, it drives so much. If you just think about, like we talked about how a capital allocation is basically held back or, you know, the way you can do it is changed by how you compensate people, you know, or constrained is a better word.

There's other things like, I mean, you think about in the context, going back to like the story about the single strategy hedge funds, you also have the similar problems where given too much leeway in an eat what you kill environment, PMs will start to set risks to suit themselves than they do for the overall portfolio. Because after all, why should they care?

You know, why should they care about the overall portfolio performance? If I can, you know, if I've made money for the first nine months of the year, you know, the temptation is to lock down risk and have Christmas, you know, enjoy Christmas rather than take more risk. Whereas the portfolio at the top level may not want that. You know, so you have all these other things that drive these decisions of people around.

you know, across so many different dimensions. It's one of the most fascinating things because, you know, at Alburn, we've done a huge amount of work trying to understand this, but, you know,

I learned Python to do this. God help me. It's just one of those things. How does the eat what you kill environment solve for the problem of the PM who's made money for nine months of the year and then want to lock it down? What types of risk controls or I guess controls for under risk? Because in a way, the thing that they don't want is someone taking some risk or

you know, getting too conservative. What are the approaches that they have to align those incentives so that you have to keep going for those final three months of the year, even if it means risking your great year? I mean, sometimes it's very simple. Minimum amounts of capital deployment required.

You know, it's kind of hard, right? Because at the end of the day, if you've got a successful PM on the year and you want to keep him or her, it's not an easy question to answer. And like, there are more hybrid approaches to the eat what you kill, right? For example, partnership. So, you know, many funds offer a partnership to the PMs where they do participate in the overall fund process.

fund profits. You know, there's other kind of, you know, fancier ways to make, you know, increase, say, the payoff to the PM depending on the fund's performance, the fund's overall performance. But yeah, it's a really hard problem because it's a comp, it's a personal relations problem. Yeah. You know, I mean, sometimes you just got to accept it. You got a guy who's up

coming to the end of the year and they're just kind of de-risking. Look, the thing beyond comp is really culture, right? And you can say comp derives culture, but it's not quite that simple. You couldn't just hire the sort of individual who won't do that. You know, and a lot of funds will talk about, we talked about the war for talent. I often call it the war on talent, but...

People go to places they want to work with people who they want to work for. And you do try to just hire professionals, regular people like us, who work through the holidays, you know, and stuff like that, you know, just to finish off for the new year, you know. You've got to hire the right people. You know what's great about your investment account with the big guys? It's actually a time machine. Log in and Zoom. Welcome back to 1999. It's time for an upgrade.

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So listening to you talk on pass-throughs versus traditional fees, the 2 and 20, I'm kind of wondering why would you ever invest in a pass-through? Because when you describe the downsides, it's like you don't have as much cooperation. Maybe it's harder to move capital around. It seems like the traditional fee structure might be the better choice here. But

Tell me why I'm wrong. Well, we've been taking, I mean, this is partially my training, taking the side of the allocator here. And you're right, like superficially at the top level, a pass-through seems like a bad idea for the allocator. But there's kind of three people, three entities getting comped here. There's the allocator, there's the manager, and there's the PM. Yeah.

And the thing is, one of the one of the standard features psychologically of most PMs is they all think they're really good. That's how you become a PM. You become ambitious. You press yourself to test yourself against the market. A pass through manager is will give you the max compensation if you are a good PM. Right. And at the end of the day, what we're describing is an industry that relies on PMs to do good work.

and who are really smart. And if you have a situation where they're going to get paid in a particular entity more than another sort, they will gravitate towards that. So the answer to your question is if allocators had their way, they probably wouldn't want to invest in pass-throughs. But the fact is that they don't have a choice. And pass-throughs are, you know, the other thing to remember is pass-throughs are good for PMs. But the interesting thing, and people do forget about this, is in a pass-through situation in a pod shop, the PM,

is getting paid from their own P&L. The manager themselves is fully aligned with the investor, with the allocator, because they're only getting paid off the netted of all the pass-throughs. They're paying off the same P&L at the top line as the investor. So there is somebody, and I mean, people do talk about how much they make and whatever. It's a fantastic, it's like, I've heard it described as the worst, best job in the world. But it's an incredible story

thing of coordination and getting people together, but they're actually incentivized and aligned with the allocator. And to give them their due, they do their best to do that because they are conscious of keeping costs under control because that's their profit margin that's feeding into. I mean, the other thing is, which is kind of scary for allocators, is the extra layer of fees, right? And it does cost money. And fundamentally speaking, the other thing that comp is driving in that case is risk, right? They're driving leverage. We've done simulations and

A pass-through manager has to be around one third more levered than the two-layer fees, two and 20 manager. I mean, they have to be because they have to make more money to pay that extra cash out. And it costs real money to do that. And, you know, in one sense, price is what you pay, value is what you get. Returns have been really good because of the pass-through manager has been a really effective business model investing side. But yeah, I mean, allocators do complain about the cost.

Something I'm curious about with the very traditional hedge fund model, which you described very good articulation. If I'm an institutional allocator, I'm diversified. Therefore, I want my allocations to take max risk. The individual hedge fund manager might not want to take mass max risk because it's their whole career and name on the line. What is actually the expectation there?

in the sort of traditional hedge fund model for like how much of the manager's net worth is in the fund and how do you establish that? And by the way, if I were a hedge fund manager who had done really well, I would buy a lot of mansions and yachts and stuff so that if my fund ever went to zero, I still would have a lot of wealth. Oh, you've thought this through, Joe. Yeah. Man,

mansions where in particular? Miami, Aspen, the Gulf States, New York City. Okay. Anyway, but like, how do they, like, how do you, how do they actually establish that the manager is fully aligned with the performance of their fund? So that is a really, really good question because opinions really vary there. Right. And the standard,

answer to that question is the majority of the manager's liquid net worth. And you can define that whichever way you want. Is there a way to audit that? I mean, I say, hey, look, I have it all in my fund. You can, you can ask the admin.

the manager can authorize the administrator of the fund to disclose their investment in the fund to you, if you ask them nicely. They don't know that I have... They wouldn't know if I had a billion dollars in Bitcoin on a private wallet that's not in any key. I'm just saying, I would... When I hear this, I saw this in your notes. When I hear this, my first mind goes to, how can I pocket net worth in places that aren't easily visible and so I'm not fully exposed to my own fund? Sorry. Look, I mean, my...

There's a bigger question there. Okay. And which you mentioned at the start of your question before you went on about the nice mansion in Aspen, which is kind of distracting me right now. But to be clear, the fact is that if you have all your money in a fund, you're kind of going to mind it differently. Yeah. Right? Yeah. And if I'm an investor who's got a hundred of funds like that, you're going to under risk it relative to what I want as an investor. Yeah.

And so it's a real dance, right? Again, it goes back to the character of the person you're hiring, which we talked about earlier on about the pod shop with a similar scenario. It really depends on how you want to risk manage your investments as an allocator, right? Because at the end of the day, when you're asking a manager to put their own capital in the fund, you're assigning them a certain role as a risk manager because they're

And you have to assess, honestly, my answer is it really depends on the person who I'm dealing with and the sort of person who I think we're dealing with, right? If I think it's somebody who is just really professional and good,

I'm not so sure that having all their money in the fund is necessary. Okay. If I think it's somebody where... And they seed other funds too? You know, big fund managers seed? They do, yeah. I mean, I used to seed at my former job. Yeah. You know, and it was a real issue because you did have people who, you know, they had made decent money. But like, what we really wanted to see at the time at PAMCO was people putting their money into the business. Yeah.

you know, paying for Bloomberg, paying for office space, you know, over putting money in the fund because that was commitment to the business. Oh, interesting. I mean, that's something that we're, you know, we were comfortable,

more as comfortable with them putting working capital into a functioning business. Interesting. Then maybe putting more, an extra 500,000, a million, 2 million, $3 million into a fund. Very interesting. So much of what you're describing, it sounds very, very granular. Like the idea of looking at individual talent to see how they operate, looking at something like culture, which tends to be difficult to define. If I'm an

allocator, how much transparency or how much information am I actually getting from one of these funds? And I realize allocators will hire your company, Alborne, to actually do a lot of this due diligence for them. But if Alborne was out of the picture, what would I be seeing if I'm a potential allocator?

So that's a long answer to that question. And it really does depend on if you're a certain size of an allocator, there's kind of the fast lane. So if I'm PIMCO or something. If you get in the executive lounge, you know, you'll get treated more, you know, get more access. And there's nothing wrong with that because simply these people have limited time, you know, and somebody who's going to be a larger client will get more in almost any line of business.

You know, in terms of access, it does vary. I think, you know, if I, you know, speaking in allocator's shoes, you know, basic stuff is regular meetings.

good substantial risk reports helping me understand where and how risk is our place you know updates when necessary and then you know just it's really it is granular it's multi-strategies are a combination of both zooming out and taking the big picture but we talked about what comp means on a global scale and how it's all that but it's also super super granular so understanding you really want to understand like where their real competency is as a multi-strat because

Many places start off with a particular kind of thing they're good at. Equities. Yeah. Right. You know, at the end of the day, most multi strategies make most of their money from kind of, I would call it equity alpha for lack of a better word, which can include traditional long short equity, quant equities, index reball. We've heard about that a couple of times, you know, all this sort of stuff. That's kind of equity alpha. Then you have other ones who have more focused on kind of fixed income and credit, you know, and you've got to understand what you're getting. And I mean,

Then you've got to think about, given what I think that my heuristic or my mental map of what these guys are, does each incremental change what they do? Does that make sense? Because, you know, I mean, one of the things I like to think about is making sure that the stories are aligned. Very simple stuff, right? Let's say I'm a pod shop manager. You're an allocator in here.

And I go on, you know, you don't ask about comp structure. Well, my PMs, you know, we put them in a room, we give them Bloomberg, we give them all the facilities they need. We charge them for that and they just get paid on their own P&L. Yeah. Oh, okay. You say, oh, fine, good. And then you say, okay, well, talk to me about, you know, what sort of culture you have. Oh yeah. Well, actually, you know what we also, you know, we have a real cooperative culture. PMs love it here. You know, they all get back massages and we all work together as a cross-functional team as well, you know, and you're kind of going,

Answer one and answer two don't make sense together. Right. And you see this in all sorts of subtle ways. You know, and the thing is that what's happened is that people have, you know, the successful funds are the ones who've answered, made answer one and answer two line up together, you know, in whichever way it needs to be. They've worked on ways that make sense, that kind of, I hate to say it, but like a narrative alignment in how they do things. They know what they're good at.

You know, like what, for example, you don't have somebody who's really, really got an equities background to suddenly decide to hire some, you know, rock star and allocate 40% into commodities.

You know, that would be kind of a weird thing. Well, so I know you're not going to like name any specific names. I will name some names, but you don't have to talk about them directly. You know, like I mentioned, someone like Ken Griffin or an Izzy Englander at Millennium. When you look at the managers who have done really well in this space, what are they good at? They are good at what I said, kind of,

Bringing alignment to different- Finding that alignment. Finding that alignment. Solving for alignment. You know, solving for kind of the business issues, the risk issues, the investment issues, and the personnel issues, and making sure that they all work together.

You know, the really successful people are just not that they are in it for the money, but now they're in it for the competition to improve. Because like I said, it's the best worst job in the world. You know, I would like to try it out at least for a little bit, see how good it is. I have a question. Part of the appeal of any multi-strategy hedge fund is the internal diversification. Obviously, whether we're talking about the two and 20 or whether we're talking about the pure pod model.

You have these periods where one trade more or less works out very well for a long time. In the 2010s, it was the disinflationary trade, which represented in rates, and it was the tech trade or various flavors of that.

What do you see when you do due diligence on a fund? What do you look for? Because I would just think, yeah, here's a bunch of people, but you all want to make money, so you all put on the same trade and different clothing, right? And there's different ways to play the same trade. How do the good funds actually establish diversification? So-

Actually, April is a really good example of diversification at work and what it means for how funds work. And I'm going to loosely describe April, very loosely. And I'm sure somebody in your audience will go, he's completely wrong. But loosely, April was mostly an equity story, right? And what we had, what we saw was equity only focus managers had a much tougher time of it than the diversified managers. Okay. Okay.

So diversified, I mean, cross commodities, rates, converts, other stuff. And why is that important? Because last year, one of the biggest trades that worked was equities, right? And so the way you stay diversified is really discipline, right? And, you know, in the context of what you're trying to do, one of the interesting things about running simulations around multistrats, right, is you actually don't need to have such great PMs or great trades to have a really good multistrat. If you risk manage it right.

OK, if you actually have a set of people who are very lowly correlated with each other and you put them together, you lever them up, you can have a very good business. So to your question is like the answer is you've got to be disciplined. You've got to have like you put the right amount of risk into your 2010 inflationary trade, put the right amount of risk into, you know, fundamental equity market neutral last year.

But you make sure that you're not over the limit, right? And you stay disciplined. But if I were equity market neutral, I would still find a way to make it long tech and disguise that. Oh, people totally do. I mean, look, we haven't even gotten into factor controls and stuff like that and so on and so forth. Look, the fact is that, and there's multiple answers to that question across how multistrats have implemented this in terms of what they're willing to take in terms of factor risk or sector risk and stuff like that. But when you get down to it, look,

The job of an investor, any investor, is to take risk in the way they're supposed to. And multi-strategy funds, they take risk. You know, there's no getting around that. Key is, is how you take it, how disciplined you stay with it, the quality of the people, the quality of the structure around that. And just, you know, sometimes some luck as well.

Just on the risk management side, it sounds like a lot depends on historical correlations when it comes to diversification. And what we've seen in recent years and in April is some of those historic correlations breaking down. So, for instance, bonds not being a good hedge for equities or more recently, the dollar selling off at the same time that bonds were selling off.

How are people managing or judging that correlation risk? Because that seems to be a potential area of weakness for multistrats. It's a weakness for everybody. Potential area of weakness for everybody. I think, look, management of correlation is super fundamental to management of risk in the context of any multistrategy hedge fund. There's tremendous benefits to keeping your correlation low between your strategies in terms of risk management.

in terms of how much you can lever, in terms of everything. When I look at managers, when I test managers, when I simulate managers,

I look at kind of two regimes, low and high correlation. And everything that works in low punishes you in high correlation, right? For example, when you're creating a diversified portfolio of really cool trades that have nothing to do with each other is great when it works. In a high correlation environment, it's a nightmare because it's things you've never heard of blowing up because, I mean, there's a limited amount of things any one person can know, right? So every choice you make at a low correlation environment will come back to bite you in a high correlation environment.

So correlations between asset classes is a fundamental part of that. But the critical thing around that is the, and this is one of my managers said to this, it's like when you're sufficiently diversified, each individual line item you add makes no difference to the portfolio risk or anything like that, except diversity.

What you're actually looking to allocate when you're at that diversified is how much of a loss you can make in that high correlation environment, how much of a loss you're willing to bear. And so if that individual component is something that's additive to that loss or makes it worse, that's where you judge it, right? When you're sufficiently diversified. So you try to insulate yourself from breakdowns and correlation by having a budget for that breakdown and correlation and making sure that your individual components, you know what each individual component of your portfolio is going to do for that.

And if you do that, then you're kind of, that's how you kind of figure that one out. Look, you can buy hedges as well. And people do explicitly do tail hedging to provide kind of return and cash and those sorts of scenarios. But allocating that tail risk, especially in a pod shop, because they're more diversified, is probably the most important job that these guys have. One of the things that I'm interested in, you know, there's still new multi-strats being launched today.

A lot of them continue to make a lot of money, but there has to be some limit to the alpha generating capacity of these vehicles, I would think. And I'm trying to wrap around my head about what happened as more and more funds launch and what is the capacity. And based on this conversation, if I had to guess about what degrades alpha over time, it would be something to do with compensation, where just like all the money accrues

cruise at the PM level because there's such competition with more. But talk to us about like how you would articulate the source of alpha and how much can realistically be captured as more and more people and more and more money flows into this space.

Okay, so articulating a source of alpha, that's probably one of the biggest questions there is in investing for hedge funds. Can I come up with a metric? I probably could in terms of just volatility of markets, alpha extraction from that. I mean, for me, the kind of critical things in terms of understanding what alpha is, is most of the time,

In most markets, there's a large number of people with different mandates, different things going on in their head, different things going on in their institutions. As long as there's a sufficient ecosystem of time horizons, capital constraints, there's always going to be an alpha. And the interesting thing about certain markets, for example, is like alpha, and this may sound a little bit philosophical, but

Alpha can be something other than money. For example, if you take a simple tail hedging situation, buying puts on the S&P, right? They're notoriously expensive, right? But the alpha that the people who buy puts get is kind of the alpha of a peace of mind for the rest of their portfolio. Yeah. Right? So, I mean, if you're hard edged to hedge funds, you're monetizing the alpha by doing a dispersion trade. But like for people who are like feel they can sleep at night by buying puts,

that's fine. They're taking their alpha in kind of non-managerie form. Now, I said that's philosophical. In other cases, you know, the hedge fund space, there's a push and a pull going on here, right? And so you talk about multi-strategies hedge funds, but they're not the only sort of hedge funds. There's a whole set of other hedge funds doing other things. And so, you know, if you just, what's been happening, and that's why we're talking about multi-strategy hedge funds is,

broadly speaking, hedge fund investing is more or less the same size for the past couple of years. But this shareable to strategies has gone up because like, as I said, they kind of offer a pretty good deal to a PM. You know, they take away all the business risk that they have to deal with. They don't have to talk to me. You know, they just get to invest in trading. We like talking to you. Thank you. But, you know, they take away all that sort of risk. And so the PMs, they kind of have a different, maybe better life depending on what their admissions are and stuff. And as I said, for investors, the underlying risk

risk-taking inside of a multistrat makes for a better kind of return level at the top level. You know, I think this will reverse, you know, over time, but like for the moment, like multistrats, and you ask about how big individual multistrats can get as well, which is an interesting question. Empirically, cap is around 50 to $50 to $70 billion right now. You know, whether that's liquidity in markets, whether that's share of Wall Street's bank's credit book, you know, that's, or whether it's just organizational size, because, you know, they're tired to manage, you

you know, hundreds of PMs, right? Physically and mathematically different to do that. Is prime brokerage a factor as well? Because I imagine, you know, if you have a multi-strat that suddenly becomes as big as JP Morgan or something, that's unrealistic. But just as an extreme example, I can't imagine the prime brokers are going to be okay with that. With what exactly? With the size and the risk of a giant multi, of having a relationship with a giant multi-strat.

They would not love it because, you know, it's this famous story of if you owe $10 to the bank, it's your problem. If you owe a billion dollars to the bank, it's their problem. So, you know, banks across the world avoid, try to avoid having customers so large that it becomes their problem. So, yes, the answer is yes, yeah.

Ronan Cosgrave, thank you so much for coming on Odd Thoughts and explaining to us why comp is important. That was fantastic. Come back on the podcast again for a further conversation. Thank you guys. Cheers.

Joe, that was fun. That was great. Yeah, I like digging into the business model of these things. One thing I hadn't come to appreciate is the idea of how difficult it might be to actually move around capital because no one wants to be firing PMs that you fought like tooth and nail to actually hire in a competitive environment. I mean, so this gets to something that actually I thought about after we did that recent episode with Scott Bach on Boutique Investment Banks.

which is the idea of where does franchise value come in in a talent-driven business? In boutique investment banking, there's another area where it's like, okay, you build this talent, but is there any franchise value external to that? And so it's really interesting to hear Ronan talk about at any hedge fund, not just the degree to which the manager has actual money tied to the investments in the space, but

but to which they're invested in the business as a business as opposed to just the fund. I thought that was super fantastic. Yeah, and also like the idea of looking at overhead spending as like an indication of how much people care about the business. Yeah. I hadn't thought of that.

You know, I would like to be in this space one day. That's never going to happen for obvious reasons. But it's very fun thinking about ways in which depending on what seat we have, we're gaming the system. So it's like if I'm at the manager level, I'm thinking about how I can have personal wealth that is visible to me but is not visible. I love that your mind –

immediately goes to gaming the system. Is not visible to the LPs. I think about how if I were at the PM level, I was like, yeah, of course I'm taking a market neutral long short book, but I'm really just finding a closet way to go long NVIDIA during the AI bull market. It does feel though that like part of the entire game is here you have these parameters and risk constraints and so forth. And this cat and mouse game between those who want to

essentially find a way out of the constraints and those who want to put them back in the box. Yeah, that seems to be a fundamental tension, although I imagine it exists, you know, in some other funds as well. And I just like the fact that all this bonus money is the business itself. I think that's a really important idea. When you hear about bonuses, et cetera, this is not just like someone getting their Christmas bonus. This is

This is the business. This is the business. Shall we leave it there? Let's leave it there. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez and Carmen Ehrman, Dashiell Bennett at Dashbot, and Cale Brooks at Cale Brooks. For more Odd Lots content, go to Bloomberg.com slash Odd Lots. We have a daily newsletter and all of our episodes.

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