Hedge Fund Investing Chapter 8: Multistrategy Funds and Funds of Funds

So you want diversified hedge fund exposure but don’t want to pick individual managers yourself. Chapter 8 covers your two main options: multistrategy funds and funds of hedge funds (FoF). There is also a third option, index replication, that has been gaining traction. Same goal, very different execution. Let’s break it down.

Multistrategy Funds: One Roof, Many Traders

A multistrategy fund is a single hedge fund firm that runs multiple strategies under one umbrella. Think equities, fixed income, credit, convertibles, global macro, all inside the same shop. The firm’s CIO allocates capital across these desks based on where the best opportunities are right now.

The fee structure looks like any other hedge fund. 1-2% management fee, 10-20% performance fee. Nothing crazy there.

Why would you want this? A few reasons.

The firm can move capital fast. If credit markets look terrible but equity arbitrage is hot, they shift money in days or weeks. No paperwork. No redemption notices. No waiting three months to get your cash out of one fund before putting it into another.

Each strategy team benefits from information shared across the firm. The credit desk sees something that matters for the equity guys. The macro team spots a trend that helps convertible traders. This cross-pollination is hard to replicate when you own a bunch of separate funds.

And there are economies of scale. Shared infrastructure, shared compliance, shared technology. A single trader couldn’t afford all that on their own.

The downside? Concentrated business risk. You are betting on one management team, one CIO, one firm’s culture and risk management process. If they get it wrong across the board, all your strategies get hit at once.

How Big Are These Firms?

Multistrategy shops are large. We are talking 100+ employees managing over $1 billion. A $5 billion firm might have 150 people split roughly 50-50 between investment pros and support staff. They need five or more prime brokers because no single broker can handle equities, commodities, fixed income, and OTC derivatives all equally well.

Most firms don’t start as multistrategy. They begin with one strategy, build a track record, hit capacity limits, then hire teams to run additional desks.

Citadel is the textbook example. Founded by Ken Griffin in 1990 in Chicago. Equities, fixed income, credit, convertible, and macro strategies under one umbrella. Over $12 billion in assets at the time the book was written. Balyasny is another one, founded in 2001, also Chicago-based, combining sector research with dynamic capital allocation across equity, macro, and credit.

The Risks Nobody Tells You About

Multistrategy sounds great on paper. But Mirabile lists some real problems.

Groupthink. When you have a strong top-down CIO view, individual traders might not push back. Everyone piles into the same directional bet. If the CIO is wrong, every desk loses at once. So much for diversification.

Hidden illiquidity. Some multistrategy funds quietly invest in illiquid or private securities. You might not find out until the fund has a big drawdown and suddenly those “small” illiquid positions are a large percentage of what is left.

Model risk. Many strategies use quantitative models based on historical data. Historical relationships break. Data has errors. Firms that rely too heavily on models and not enough on human judgment can get blindsided.

Leverage dependency. If prime brokers suddenly change margin requirements, a highly leveraged multistrategy fund can face massive margin calls with very little warning. This is what blew up several funds in 2008.

Counterparty risk. If one of your prime brokers goes down (hello, Lehman Brothers), you can lose a lot of money even if your trades were right.

Performance Numbers

Despite these risks, multistrategy funds have actually delivered the best overall performance of any hedge fund category. Higher annualized returns, lower volatility, better Sharpe ratio, and more alpha than global macro, long/short equity, fixed income relative value, or convertibles.

The strategy grew from under $50 billion in AUM in 2000 to almost $300 billion by 2007. It dropped to $200 billion after the 2008 crisis but recovered to over $320 billion by 2012.

Since 2008, investors have generally preferred multistrategy funds over funds of funds. And with good reason.

Funds of Funds: The Middleman Approach

A fund of funds is different. An FoF manager doesn’t trade anything. They pick other hedge fund managers. They evaluate hundreds or thousands of managers, build a portfolio of 15 to 100 underlying funds, and charge you a fee on top of whatever those underlying funds charge.

The fee math hurts. Underlying hedge funds charge 2% management and 20% performance. The FoF adds 0.5-1% management and 5-10% performance on top. Total: roughly 2.5% and 30%. Expensive.

What do you get? Research expertise, access to closed managers, risk management across the portfolio, and instant diversification. For pension plans without in-house hedge fund teams, this can make sense.

The FoF Problems

The FoF model has some structural weaknesses that became painfully obvious during 2008.

Slow capital reallocation. When an FoF wants to move money from one strategy to another, it has to redeem from one fund first. That can take months. A multistrategy fund does this in days.

Overdiversification. With 100 managers in a portfolio, you can diversify away all the alpha. You end up paying hedge fund fees for market-like returns.

Leverage abuse. Before 2008, many FoFs used leverage on top of already-leveraged underlying funds. When markets tanked, they couldn’t liquidate fast enough. Loans exceeded collateral values. Massive losses followed.

Madoff exposure. Some FoFs had invested with Bernie Madoff. The resulting fraud losses destroyed investor confidence in the FoF model for years.

Reporting delays. Because the FoF has to collect information from all its underlying managers before reporting to you, everything comes late. Monthly reports, tax documents, performance data. All delayed.

The FoF industry peaked at nearly $800 billion in 2007. After the crisis, it lost over $250 billion and has struggled to recover. Many smaller FoFs closed or merged. The survivors are big names: UBS, Blackstone, Man Investments, HSBC, Goldman Sachs.

Index Replication: The Budget Option

There is a third path the book briefly covers. Index replication products try to deliver hedge-fund-like returns using exchange-traded futures and factor analysis. No manager selection. No double fees. Just math that approximates what the broad hedge fund universe returns.

HFR’s product (HFRq) tries to maximize correlation to the HFRI Fund Weighted Composite Index using systematic trading of futures contracts. Lower fees, daily liquidity, full transparency. You won’t get alpha from a top manager, but you also won’t get Madoff’d.

So Which One Should You Pick?

The book doesn’t give a direct recommendation, but the trend is clear.

Before 2008, FoFs were the default entry point for investors new to hedge funds. Since 2008, multistrategy funds have taken over as the preferred diversified hedge fund product. FoFs have been losing market share every year. Replication products are growing from a small base.

If you have the resources to evaluate a multistrategy manager, that is probably the better bet. One fee layer, faster capital reallocation, better performance historically.

If you are a pension fund with no hedge fund expertise, an FoF still makes sense as training wheels. Just watch those fees and check for leverage usage.

And if you just want cheap, liquid, diversified hedge fund beta without the headaches, replication products are worth a look.

Previous: Chapter 7 | Next: Chapter 9

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.