Are Multi-Strategy Hedge Funds Really Worth The Higher Fees? It Depends On Whom You Ask

Long/ short equity has long been the most popular hedge fund strategy among investors, but that could be changing. After 2022’s massive outflows for the strategy and the hedge fund industry overall, multi-strategy funds are catching up to long/ short equity.

However, one expert is downplaying the increasing interest in multi-strategy hedge funds, suggesting that he could replicate the average multi-strategy fund using the S&P 500 and cash.

Outflows from long/ short equity to multi-strategy

In a recent white paper, Peltz International declared that multi-strategy hedge funds are close to surpassing long/ short equity as the largest hedge fund strategy. The firm reported that multi-strategy hedge funds have doubled their assets since 2011 and have been growing rapidly relative to industry assets.

In 2010, multi-strategy funds accounted for 18.7% of total hedge fund industry assets. As of the third quarter of 2022, that share had grown to 23.5%, according to data from HFR.

Turning to data from eVestment, Peltz notes that multi-strategy funds are the second-largest primary hedge strategy with $654.3 billion in assets. Meanwhile, long/ short equity hedge funds held $681.8 billion in assets after last year’s massive redemptions.

Long/short equity hedge funds recorded outflows of $37.6 billion in 2022, the most of any strategy. However, multi-strategy funds were one of only two strategies to record investor inflows in 2022, racking up $5.8 billion in inflows last year. The other strategy to see inflows in 2022 was managed futures, with $6.2 billion in inflows.

Overall, the hedge fund industry recorded $111.3 billion in outflows in 2022, bringing industry assets under management to $3.4 trillion. Last year’s outflows marked the second-largest annual redemption in hedge fund history.

Why investors may be drawn to multi-strategy hedge funds

According to the Peltz team, investors like multi-strategy hedge funds because their returns tend to be “very smooth and predictable” and are “not generally disrupted when markets become volatile.”

James McElroy of consultancy LCG Associates believes that multi-strategy platforms are probably the most expensive hedge funds. However, even net of fees and expenses, he believes many funds “offer differentiated return profiles that investors can’t achieve elsewhere.”

McElroy said he has seen mutual funds try to replicate the types of return profiles generated by multi-strategy funds, which involves producing “non-correlated returns using liquid securities.” However, he added that mutual funds have had “limited success” with such attempts.

McElroy expects hedge funds will continue to dominate in this area, adding that it goes back to what investors want, which is “pretty consistent” returns of 5% to 12% net of fees, regardless of the market cycle. Of course, he noted that every fund has negative years from time to time.

A differentiated return profile

However, McElroy adds that multi-strategy funds offer “something like a bond profile that has better returns.” He believes this differentiated risk profile is “what investors have always been looking for from a hedge fund.”

According to McElroy, investors can depend on multi-strategy funds to generate positive returns in most years — barring a “2008-type scenario.” He explained that multi-strategy platforms are differentiated in that they allocate capital to multiple trading teams and can quickly adjust their allocations when arbitrage opportunities appear.

Multi-manager firms often utilize hundreds of traders and teams. For example, Millennium Management has more than 300 teams, while Point72 has over 150. Multi-manager firms typically focus on controlling risk by cutting assets or terminating traders if they take on too much risk or underperform.

Robust returns amid 2022’s turmoil

Multi-strategy funds generally posted robust returns for 2022, even as most hedge funds struggled against challenging macroeconomic conditions. Data from Aurum shows that multi-strategy was the best-performing master strategy last year, with a return of 9.5% — compared to the hedge fund composite’s decline of 2.42%.

Meanwhile, the S&P 500 plunged 19.4% last year, while the Dow Jones Industrial Average was off by 8.8%, and the Nasdaq plummeted 33.1%. According to Aurum’s data, quantitative was the second-best strategy in 2022, with a return of 8.5%, followed by macro’s return of 6.7%.

Aurum reported that multi-strategy funds generated positive returns in every month of 2022 except May. However, a handful of very large funds dominate the strategy’s assets and returns. In fact, many of the most well-known and reputable multi-strategy funds knocked their returns out of the park in 2022.

For example, AQR’s Absolute Return Strategy generated an estimated return of 43.5% for 2022. Citadel’s four multi-strategy funds also generated sizable returns ranging from 17.8% for its Equities fund to 38.1% for its Wellington fund.

Meanwhile, DE Shaw’s Composite fund’s 2022 return was estimated at 24.7%, while Brevan Howard’s Master and Alpha Strategies funds generated estimated returns of 20.14% and 28% for 2022.

On the other hand, not all multi-strategy funds generated robust returns last year. Peltz estimates Sculptor Capital Management’s
return at -13% for 2022.

Multi-strategy has remained the standout performer over the last decade

Although multi-strategy funds have only captured the spotlight over the last couple of years, Aurum reported that the strategy has been a standout performer for the past decade. Multi-strategy funds have generated consistency and the highest absolute and risk-adjusted returns.

The strategy generated a five-year compound-average return of 9.46% with a Sharpe ratio of 1.87. The strategy’s 10-year compound-average return stands at 8.3%. Aurum also noted that multi-strategy funds have remained resilient against market factor risks.

The firm described the strategy’s dollar alpha generation as “phenomenal” with “minimal” performance attribution to beta.

Criticism of multi-strategy funds

While Peltz said investors couldn’t replicate multi-strategy hedge fund returns, Nicolas Rabener of Finominal said recently that he is able to do so using the S&P 500 and cash. Contrary to what the data from Aurum, Peltz and other sources on multi-strategy hedge funds indicated, Rabener also said a “few select” multi-strategy funds generated outsized returns in 2022, but the average fund “lost money.”

He added that the expected return of multi-strategy funds should be “low, but consistently positive and not very volatile.” However, the outsized returns from funds like Citadel and others “had anything but these features.”

Rabener approached the increasing popularity of multi-strategy hedge funds from a different angle. Data from BarclayHedge showed multi-strategy funds had about $300 billion in assets under management between 2017 and 2020, a number that doubled in the following years.

He suggested that the increased assets under management could indicate that those funds did well during the COVID-19 pandemic that started in March 2020 and were then rewarded with new capital. However, his calculations suggested the market share of multi-strategy funds as a proportion of the hedge fund industry’s total assets grew only marginally from 12% to 14% in the last five years.

Thus, Rabener attributed the increase in assets under management by multi-strategy funds to the growth of the entire hedge fund industry, which saw its assets rise from about $3 trillion to $4 trillion in 2020. He also questioned how much of that growth could be attributed to inflows from allocators versus existing assets appreciating in value.

Rabener’s conclusions on multi-strategy funds were totally different from those of Peltz. To evaluate the performance of multi-strategy hedge funds, he looked at the HFRI indices from HFRX for multi-strategy hedge funds focused on equities, event-driven, macro and relative value. Theoretically, the returns of these four types should be totally different, but their performances since 2008 were “remarkably similar.”

Replicating multi-strategy funds?

According to his calculations, the 36-month rolling correlations of the event-driven, macro and relative value strategies to the equity strategy ranged from 0.6 for macro to 0.8 for event-driven. Those correlations are too high because they should be totally uncorrelated due to the different areas of focus.

Of course, those correlations also suggest the four types of multi-strategy hedge funds offered the same risk exposure. Rabener also calculates the 36-month correlations to the S&P 500 and found that they ranged from 0.6 to 0.9, with global macro offering the largest diversification benefits.

He added that multi-strategy fund managers appear to offer only beta to equities, contrary to Peltz’s findings. Rabener also claims to be able to replicate the return profile of multi-strategy hedge funds using a portfolio made up of the S&P 500 and cash. He claimed that allocating 40% to stocks and 60% to non-interest-bearing cash would have generated a performance almost identical to that of multi-strategy hedge funds between 2008 and 2022.

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