Is the Multi-Strategy Fund the New Fund of Funds, or Something Else?

Since the 2008 market disruption, the popularity and influence of fund-of-funds (FOFs) has changed significantly.  The classic fund-of-funds model has been called into question on many fronts over the past decade.  That said, the current landscape of available FOFs is diverse and varies across different regions, trading styles and market conditions.

The Fund of Funds – Challenges since 2008

Here are some developments that hit the fund-of-funds community hard following the 2008 crisis:

• Loss of investor confidence:  The 2008 financial crisis resulted in a significant loss in followers, as many funds of funds were unable to deliver the returns that investors expected, returns that seemed surprisingly undifferentiated FOF vs FOF.  This led to redemptions and outflows from these funds, causing a significant decline in their size and numbers.
• Fee concerns:  Fund-of-funds typically charge an additional layer of fees on top of the underlying hedge funds they invest in. The financial crisis and subsequent scrutiny on fees prompted investors to seek more cost-effective investment options, such as direct investments in hedge funds, managed account platforms, or alternative structures.
• Performance issues:  FOFs have covered everything from long/short equity, credit, global macro, managed futures, and options/volatility programs to other specialized approaches. With the exception of the 2020 Covid crisis, the North American stock markets underwent an historic 12-year rally, fueled by easy money.  The market attracted investors seeking quick and substantial gains, and left them with higher performance expectations.  In contrast, the traditional FOF appeared stodgy, fee-laden and overly complicated.  The low volatility that accompanied the bull market did not help either, reducing the opportunities that many strategies within FOFs typically exploited.  
• Better access to individual funds:   With the growth of technology and increased transparency in the investment industry, investors have gained better and more direct access to individual hedge funds. Platforms and services have emerged that allow investors to directly invest in curated portfolios or specific funds, bypassing the need for FOFs.

Recent Resurgence?  

Nonetheless, some are now saying that recent market disruptions, such as those experienced between 2020 and the present, may have stoked renewed interest in the fund-of-funds model. The recent, more volatile, market activity has created both challenges and opportunities for FOFs.  The effect depends on the FOF’s focus.   Certain types of fund-of-funds (e.g., those focused on long-short equity or fixed income strategies) may be facing difficulties in navigating these new conditions, while others (e.g., those focused more on global macro, commodities or managed futures) have thrived.

The degree of the FOF’s diversification and ability to spot talent (including newer and emerging strategies) have also been factors.   Those fund-of-funds that adapted quickly to changing market conditions and effectively identified hedge funds that have performed well should attract more investment.  Also, the FOF model has evolved since the 2008 crisis from a structuring standpoint, with many adopting new strategies and structures to address the model’s previous shortcomings.  More selective manager due diligence and tailored investment approaches have helped many regain investor confidence.

But the final factor noted above – new structures – may be the most interesting.  If the multi-manager model has returned to the forefront, it may have returned in a new form.

Enter the Multi-Strategy Fund

One such form is the multi-strategy fund, or “multi-strat” for short. Such funds are not necessarily new. Managers like Millennium, Citadel, Balyasny (and in the past, FrontPoint) have been in the market for years. But, according to an October 2022 article in the Financial Times, assets in fund-of-funds have remained largely constant, even decreasing slightly, since the early 2010’s, while multi-strat assets have soared in recent years.  

So, what exactly is a “multi-strat” and how does it differ from the classic fund-of-funds:

1. Diversification of Investment Approach. Multi-strategy funds typically employ a broader investment approach by combining multiple investment strategies within a single fund. These strategies can include long/short equity, credit, macro, managed futures, volatility, quantitative, and other specialized approaches. Traditional fund-of-funds, on the other hand, typically focused on certain strategies or sectors (e.g., long-short equity only, credit only, etc), to the exclusion of other strategies.  Also, multi-strategy funds tend to use more internal (or proprietary) strategies and/or newer (or emerging) strategies. The classic FOF, in contrast, has typically invested in larger, established external managers.
2. Control over Investment Decisions and Exposures. Traditional fund-of-funds invest in external hedge funds, limiting their direct control over, including liquidity in, underlying investments. This lack of control can affect transparency and decision-making. In contrast, multi-strategy funds have more direct control over the strategies and investments within their own fund, potentially enabling better transparency and decision-making processes.
3. Fund structure: Multi-strategy funds are typically single funds managed by a single investment manager or management team, who make the decisions on allocations and risks. Accordingly, allocations are almost always made via direct managed accounts, not into funds. Traditional fund-of-funds, in contrast, have tended to invest in a variety of external hedge funds, leaving risk control and leverage decisions to these external managers.
4. Transparency: While both multi-strategy funds and fund-of-funds may involve varying degrees of transparency, generally speaking the manager of the multi-strategy fund enjoys more visibility into the underlying investments, but are much less likely to share it. Traditional fund-of-funds offer less transparency largely because are stuck with the more limited transparency of a fund investor.
5. Leverage: Both multi-strategy funds and fund-of-funds have the potential to employ leverage, but it is not a defining characteristic of either. Many, if not most, multi-strategy funds may utilize leverage to amplify their investment positions. Fund-of-funds may or may not employ leverage, but are more constrained given that they have less latitude given the fund structure (see above).
6. Scale and Resources. Operating a traditional fund-of-funds did not require a great deal of infrastructure or resources.  Multi-strategy funds are often large institutional investment firms with significant resources, including dedicated research teams, risk management departments, and infrastructure. This scale allows them to access a broader range of investment opportunities and implement more sophisticated strategies compared to traditional fund-of-funds.

There are many parallels between multi-strategy funds and traditional fund-of-funds. Some investors have even suggested that the multi-strategy fund is merely a more levered and less transparent fund-of-fund. But this argument misses a few things. Multi-strategy funds tend to offer a larger number of – and sometimes broader range of - investment strategies within a single fund. Traditional FOFs, in contrast, allocate capital to a narrower set of external hedge funds.  

The multi-strat manager also exercises much more control and risk management over its constituent investments, whereas the FOF manager typically has a “hands off” approach. Many multi-strats actively involve themselves in the underlying strategies – adding alpha by finding ways to maximize the manager’s strengths and minimize their weaknesses.

But like many things in the investment world, just because the multi-strategy fund is popular doesn’t mean it’s perfect. The most frequent criticism is the lack of transparency. In short:  Is my multi-strat fund “doubling up” on exposures (e.g. long equities) that I already have, that I may even be trying to diversify away from? Another concern is the fund’s potential conflict of interest: When the trader employed by the multi-strat is owned or controlled by multi-strategy fund itself, there may be conflicting incentives. While the multi-strat can remove an underperforming trader at any time, it may be more prone to give them a “longer leash.” Also, while many multi-strat fund managers try to appear to be as “generalist” and diversified as their FOF counterparts, many can become biased toward one particular strategy (or group of strategies); if the fund needs to become more diversified this means it may not be armed with the expertise necessary to expand into other strategies.

Another question some investors have raised about multi-strats is whether there’s selection bias in retaining the best trading talent. Most successful traders tend to be independently minded risk-takers that tend to be more entrepreneurial. Most of these individuals left a larger hedge fund or proprietary shop in order to venture out on their own. Such managers are wary of multi-strats – which they fear will lock up their capacity and restrict their freedom of movement for a number of years.

Last, there’s the fee question. The classic FOF has been criticized for “layering on fees upon fees.” Many have recently criticized the larger multi-strat funds for being equally, if not more, gluttonous with fees, just less obvious about it.  Many multi-strats “pass through” many costs that FOF managers typically eat themselves – e.g. cost of research, travel, risk management systems, etc. And, as multi-strats tend to employ leverage more often, investors also bear the burden of the interest cost of such leverage.

The Better Option:  The “Transparent and Trader Friendly” Multi-Strat

Perhaps the best solution for an investor is some blend of these two models: A multi-strategy fund that is more open and transparent – not just more open about the strategies but also about fees and costs – and less insistent on locking up the trading talent.

Such a hybrid approach might also be less insistent on maintaining direct managed accounts with the managers. A direct SMA offers many benefits over allocating out to an external hedge fund (liquidity, transparency, ability to lever and/or cross-margin). But running multitudes of SMAs in a multi-strat fund is not only operationally intense, but also restricts the types of managers the fund can allocate to. Some managers (including even newer ones) have extremely high minimums for a direct managed account, or simply don’t want another SMA on their books. 

And the irony is that very few of the larger multi-strats pass on the liquidity benefits of SMAs on to their clients. This new “hybrid” multi-strat could assert itself as having the potential to be even more liquid than either FOFs or traditional multi-strats.

By strictly adhering to “SMAs only” the multi-strats are neglecting other types of vehicles that can deliver many of the desired liquidity and leverability features of an SMA – e.g., swap-based platforms or levered managed account platforms come to mind.

This hybrid solution would also address the most serious challenge to the future of the multi-strat: obtaining and retaining new trading talent. Where the classic FOF tended to ignore newer and emerging managers (even in the face of data showing that such managers generated better returns),  the modern multi-strat embraces them.  In fact, the multi-strats love them so much they often demand exclusivity. Perhaps the next generation of multi-strat funds will realize something we, as the operator of a managed account platform, learned a long time ago: Set them up for a career, not servitude.

Conclusion

In summary, multi-strategy funds offer several advantages over traditional FOFs. Their diversification typically invites a broader range of traders and strategies, including proprietary and emerging ones, resulting in a more distinctive and unique investment portfolio. The direct control the multi-strat manager has through managed accounts allows for more hands-on control over risk and exposures versus the FOF, which is typically at the mercy of the external hedge funds.  

Moreover, the scale and resources of multi-strategy funds, with dedicated research teams and robust infrastructure, provide access to a wider array of investment opportunities and the ability to implement sophisticated strategies. To tap these advantages, however, investors may have to accept selection bias, conflicts of interest, rising fees, and the risk that the fund manager may have difficulty securing new talent.

A hybrid approach - one that blends the strengths of open transparency, reduced restrictions on trading talent, better liquidity for investors, and diversified allocation methods –may provide investors with a better solution. By allowing more transparency into the strategies (including their performance) as well as in fees and costs, multi-strat (and FOF) managers will earn trust with investors. While the multi-strat is currently sexy, investors will tire of investing high minimums into a high-priced “black box.”  Lastly, not requiring 100% direct managed accounts with all the underlying managers, and employing SMA-like proxies, can expand the range of available managers. By embracing this hybrid model, multi-strategy funds can adapt to the evolving landscape, attract new trading talent, and deliver enhanced outcomes for their investors.

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Jon Stein is CEO at Kettera Strategies

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group