Peak pod shop – Where to next?

Over the last four years we have published several pieces about multi-manager platforms (commonly referred to as pod shops) highlighting “the good, the bad and the ugly”. In each of the last four years we have witnessed over a dozen new launches, and this year is no exception. They all claim to be in niche strategies that eventually become victims of their success and soon face the inevitable growing pains of scaling up followed by diluted returns as they grow their assets too rapidly. Very few have survived the test of time and remained successful despite their phenomenal growth in assets. One could argue that the largest pod shops today all started with a much smaller base and performed way better in their beginnings.

Reuters recently reported that 38.3% of the entire hedge fund industry’s returns over the past three years were generated by Citadel, Millennium and D.E. Shaw, which represent only 4.6% of the industry’s entire assets under management. As the three have been around for 25 years and each have around $60 bio under management, this is quite a remarkable achievement. Add Point 72 (formerly SAC Capital) to the mix and you have the largest pod-shop juggernauts in the world (Ex DE Shaw) representing 42% of the entire pool of pod shops.

Over the last two years there have been several papers published by various prime brokers about pod shops and they all highlight the fact that the larger the pod shop and the larger the passthrough structure, the better they perform. Hence this month’s chart, which illustrates their average performance in 2023 and the impact of fees (“the ugly”) eating into gross performance. The industry has increasingly been confronted with a never-ending game of musical chairs as the war for acquiring talent continues unabated. As a result, pod shops are getting overly expensive thanks to the pass-through structure and yet clients are happy to pay as they are yet to suffer from significant drawdowns (bar a few exceptions in 2008) single hedge fund managers face at some point in their career. At NS Partners we have obviously benefitted from them, as our low volatility mandate has achieved an annualized return of 5% (net of fees) with a volatility of under 2% over the last 3 years. This is essentially what pension funds needed during a zero-interest rate environment but now that cash yields the same, the bogey has changed. Now the time has arrived for the next evolution of our low volatility mandate which we had initially overhauled back in the summer of 2020.

So where do we go from here as not all pod shops are created equal. Talent is scarce and not scalable which enables the smaller pod shops to generate superior returns (as long as they intend to stay small and hence uninteresting for the large pension funds/endowments). Like single manager hedge funds, size and leverage can become your biggest enemy exposing you to left tail events, especially in a sudden deleveraging environment following a market shock or liquidity event. With a footprint of 30% of US equities in 2023 according to Goldman Sachs, this makes them larger than that of the traditional single manager equity L/S funds. The footprint is even larger in terms of headcount where it is estimated that they account for over a quarter of the industry’s headcount (the 3 largest pod shops alone have over 12,000 employees). The biggest risk is a flash crash or August 2007 type of forced unwind that ripples across all the pod shops that have built-in circuit breakers (strict stop loss policies). Given the amount of leverage involved this could potentially have a huge impact in terms of musical chairs but as in August 2007, ironically the last one standing (or sitting out the storm) turned out to be the winner!

Perhaps the more interesting model today is a smaller and more concentrated version with seasoned external managers that run their own boutiques and have no interest in being hired by a pod shop but contribute and get paid for their ideas like a traditional alpha capture model. The difference here is that the focus is not on the batting average of a PM (that then gets levered up in a traditional pod shop to produce decent returns) but on the slugging ratio i.e. how good they are at successful versus losing trades. Add to the mix a central trading layer to hedge out factor risks as opposed to having a hard and fast stop loss rule irrespective of the investment thesis et voila! Let’s face it, most single managers have been caught off guard on numerous occasions in the last few years by severe factor rotations which could be blamed on the quants or the deleveraging effect of crowded trades among the pods. This obviously applies to equity long short strategies where most of the pod shops have their roots but so far it has been interesting to see quite spectacular results from tier 2 and even more so from the tier 3 pod shops. Let’s hope they can continue to deliver double-digit returns without growing exponentially (and maintain competitive fees!).

Pod shop fees don’t come cheap these days and long gone are the days when our friend George Soros annualized at 33% net over 30 years (if you could stomach the volatility) with a 1% management fee and a 15% performance fee…

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