Global hedge fund assets hit roughly $4 trillion as of June 30, 2021, up more than 4% from the previous three months, according to HFR Inc.

Rising interest in hedge funds follows the recent returns witnessed in the asset class. For the year ended Aug. 31, 2021, the HFRI Event-Driven and HFRI Multi-Strategy indexes were reportedly among the top-performing strategies, both returning 25% on a one-year basis.

Hedge fund index returns

Source: Pensions & Investments, September 2021. “Hedge Funds Build Momentum.”

Multi-Strategy hedge funds combine a variety of different investment strategies that are generally uncorrelated, with the goal of delivering a less volatile return stream to investors. Each investment strategy is typically executed by a portfolio manager (PM) who is dedicated to their respective strategy. These strategies can span the full spectrum of markets, including but not limited to equities, credit, and derivatives. Additionally, these strategies can either be specific and narrowly defined (i.e., trading precious metals) or broader in nature (i.e., trading all commodities), depending on the individual manager.

Multi-strategy funds can operate under either a single manager model or a multi-manager model. Under both models, the fund managers’ leadership will have broad discretion over which strategies or sectors capital is allocated to. The key differentiator is how involved the firm’s management is once the allocation has been made to the dedicated teams. In the single-manager model, the firm’s management will be more involved in individual security selection. In the multi-manager model, once an allocation has been made to a strategy or sector, the PM will typically have total discretion within their defined investment universe. Under both models, capital can be dynamically allocated depending on the shifting opportunity set.

The Fund’s objective will help shape which strategies capital is allocated to. For example, a multi-strategy hedge fund may have an objective to provide returns with a low correlation to traditional risk assets. This objective will likely lead the fund manager to find low-beta strategies to help support the objective.

A multi-strategy hedge fund helps provide investors with diversification since the fund houses different strategies. However, as mentioned above, these strategies are often dictated by the fund's objective, meaning that the type of strategies employed will depend on what the fund is designed to do.

A common analogy is to think of a multi-strategy fund as similar to a Fund of Funds (FoF) because both structures employ different portfolio managers under a single fund structure. For fund of funds, one fund invests in multiple hedge funds to diversify its hedge fund portfolio. Conversely, with multi-strategy funds, one fund employs different portfolio management teams, but each team is housed within the single fund structure. This subtle difference plays out into varying advantages and drawbacks within each structure.

Capital Allocation

For a fund of funds, the fund manager selects hedge funds to include in their overall portfolio. While this allows the fund of fund manager diversification, one of the challenges for fund of fund managers is that these decisions need to coincide with the underlying hedge fund's subscription and redemption cycle, which may delay the process of implementing changes to the portfolio. For example, if a prospective underlying hedge fund accepts new subscriptions monthly and offers redemptions every three months, then the FoF manager is only able to add new capital at the end of the month and redeem every quarter. As such, this mismatch results in a FoF manager needing extra time to make portfolio changes and lessening their ability to be dynamic during changing market conditions. Conversely, since multi-strategy managers work within the same fund, the manager can be more dynamic with their allocations and respond quicker to market dislocations.

Lessons Learned: 2008

The GFC in 2008 provided a lesson to fund of fund managers on liquidity management. As mentioned above, FoF managers need to consider the liquidity terms of the underlying funds when managing their portfolios. However, most funds have “gates”, which limits the amount of redemptions to a percentage of a fund. For example, if a fund offers quarterly liquidity with a 10% gate, the fund will allow investors to redeem every quarter, if redemptions remain under 10% of the fund. Once redemptions exceed 10%, per the example, the fund will limit or suspend redemptions. The gates help to preserve the portfolio from being fully liquidated if redemptions exceed what is needed to maintain the portfolio.

Gates are usually hit in extreme market conditions when redemptions are higher than normal. In 2008, as investors were pulling out of the market to preserve their capital, some hedge funds were forced to implement these gates, which proved to be challenging for fund of fund managers.

Fees

With a fund of funds, investors will have two layers of fees, one layer from the underlying hedge fund and the other layer from the fund of fund manager choosing the underlying hedge fund managers. For multi-strategy hedge funds, investors receive one fee from the fund since the underlying PMs fall within the same fund. The compensation of the underlying PMs gets rolled up into the multi-strategy hedge fund fees.

There is a key differentiator between single manager and multi-manager funds with regard to performance fees. Many multi-manager funds have what is called a pass-through fee model. This means that PM expenses, including performance fees, are passed through to the end investor. This ensures that winning PMs will be paid even if the overall fund is flat or even loses money. This is important because it helps ensure that the fund manager can retain its top-performing investment talent in all environments. This is referred to as netting-risk. In fund of funds and multi-manager funds, it is typically the end investor who takes on the netting-risk. In a single manager fund, the firm’s manager will be responsible for compensating top-performing talent during a flat or down period of performance or risk the talent departing for another firm. In this scenario, it is the Fund manager who is assuming the netting-risk.

Potential allocators to multi-strategy hedge funds should pay particular attention to the risk management and service providers in place to assess whether the fund is equipped to manage the portfolio.

Risk Management

A drawback to multi-strategy hedge funds is the complexity in managing the risk of the fund's overall portfolio. While employing various PM teams offers diversification in the portfolio, the teams are often siloed to their respective strategy, making it difficult to attribute each portfolio team’s impact on the overall portfolio and potential overlap. This is where the multi-strategy manager steps in with a risk management team to monitor the correlation of the underlying portfolio and review whether the portfolio is in line with the fund's objective. The multi-strategy manager will often work with the risk management team to establish parameters for each PM team to follow. As a result, each manager, in theory, has provided a unique set of guidelines and portfolio constraints. This structure may also reduce the level of transparency an investor can experience given the difficulty of aggregating individual portfolio level exposures.

Manager Diversification

The shared resources across the multi-strategy fund can pose a business risk for investors. Under multi-strategy hedge funds, each team shares the resources of the fund and is reliant on the functioning capabilities of the firm to execute its strategy. If the multi-strategy firm falls deficient in its infrastructure, an investor is wholly exposed to that risk, whereas in a fund of fund structure, the business risk is diversified across a series of funds. Within a fund of fund structure, investors diversify away their exposure from a single manager.

About 31% of investors planned to increase their multi-strategy allocation in the second half of 2021, up 25% from the first half of 2021, favoring the multi-strategy hedge funds’ versatility in the expected market environment.

Proportion of investors planning to increase their allocation to top-level hedge fund strategies in H2 vs. H1 2021

Fixed income allocators seem to be hedging against today's low-rate environment eroding value in fixed income, especially with the recent inflationary pressures plaguing the market. This has prompted a net 27% of investors planning to move out of fixed income. According to the recent study by AIMA, allocators have been increasingly looking at hedge funds with net neutral equity plans as a risk-adjusted alternative, as evidenced in the year-to-date flows through May 2021 of $8.8bn to these multi-strategy hedge funds.

Hedge fund asset flows ($Bn) through May 2021 by investment strategy

Source: AIMA, July 2021. "Investor Intentions H2 2021."

In taking a deeper dive into multi-strategy hedge funds, we have noted that these funds can operate with a variety of trading teams employing different strategies to serve the overall portfolio objective dictated by the multi-strategy manager. Multi-strategy hedge funds can offer an opportunity to achieve lower correlated returns through the diversity of PM teams and a diverse set of trading strategies within one fund. However, monitoring the risk and performance of the overall portfolio can prove to be challenging for a fund manager. Multi-strategy hedge funds require proper risk management protocols and infrastructure to obtain the requisite insight into the overall portfolio.