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The most successful funds in recent years have pursued multiple strategies, while avoiding risk.

The stars of the hedge fund world used to take big swings and sometimes hit grand slams, like John Paulson when he shorted the U.S. housing market before the 2007-09 financial crisis and made $20 billion.

But swing-for-the-fence hedge funds haven’t been the big winners in recent years. Instead, the best returns have come from the multistrategy, multimanager hedge funds that rivals derisively call “pod shops.”

Multistrategy shops like Citadel and Millennium Management continuously shift bets around their firms’ roster of strategies and portfolio managers. What they have over single-strategy shops is that they reliably make money.

Annual returns at Citadel have ranged from 15% to 38% in the past five years, as founder Ken Griffin and his colleagues moved capital among dozens of teams—some finding interest-rate plays, commodity speculations, or quantitative patterns, others going long or short on specific stocks. Returns at Izzy Englander’s Millennium ranged from 6% to 26% during the same period.

Ruthless risk controls shield these multistrategy firms from deep losses and broad-market swings. Their combination of strong returns and low volatility has attracted the lion’s share of the new cash flowing to the hedge fund industry over the past half decade. Multistrategy funds now manage some $400 billion.

But lately, Wall Street has been wondering if hedge funds have reached Peak Pod.

Returns dropped markedly at many multistrats in 2023. The average fund in the class returned 5.4%—even as the Nasdaq Composite and the S&P 500 cranked out total returns of 45% and 26%, respectively. For underperforming multistrats, there could be trouble ahead. The category employs a quarter of the hedge fund industry’s head count and pays top dollar for talent, then passes those expenses to investors through high fees. If returns ebb, investors might question those fees.

Pension funds and other asset allocators have become a bit less smitten with multistrategy funds, Goldman Sachs researchers tell Barron’s. While about 21% of respondents to a Goldman survey would like to add to their investments with multistrats, the proportion who would like to reduce their exposure rose to 8% last year, compared with 4% in 2022.

That may make it harder for new multistrats raising capital. When Bobby Jain, a former top executive at Millennium, set out to start his own fund last year, news reports said his Jain Global Management was hoping to start with $10 billion under management. That would have been a hedge fund record. Since starting to raise capital in earnest this year, however, the new multistrat now aims to launch in July with $5 billion to $6 billion.

“Investors are increasingly feeling fully allocated,” says Jon Caplis, CEO of hedge fund research firm PivotalPath. “Not necessarily negative, but less interested in adding to these positions.”

The top performers in the category have no trouble attracting more investors. In fact, they are giving money back. Citadel is returning $7 billion after 2023 gains swelled its assets to $63 billion. The quant multistrat D.E. Shaw Group is returning all of last year’s profit from its largest fund after a 2023 gain of 9.6%.

Since its launch in 1990, Citadel’s flagship Wellington fund has returned 19.6% a year on average, compared with 10.7% for the S&P 500. The firm now manages about $60 billion, as does Millennium. In contrast to daring, single-strategy heat seekers, the multistrats pursue the cold ideal of good returns but low volatility.

“Hedge funds are supposed to deliver diversifying returns regardless of whether the S&P goes up or down,” says David Kabiller, who co-founded the multistrat quant firm AQR. “Multistrategies have been the tortoise to the single-strategy hare. What wins in finance is the more consistent player.” For its part, AQR’s oldest multistrat fund was up 18.5% last year and has been consistent in its gains.

When Griffin and Englander were starting their funds in the 1990s, the preferred approach among hedge funds was for a star investor to start a stand-alone firm and specialize in a favored strategy. Pension funds and endowments built diversified, uncorrelated portfolios by allocating their money among different single-strategy firms. Fund-of-funds firms also spread capital among talented specialist firms, seeding a short seller here and a bond trader there.

“Single-manager firms pioneered deep fundamental research,” says a multistrat executive who started his career at traditional long/short funds. “But they did not think a whit about risk management.” Many stars of the single-manager era eventually suffered losses that scared away investors. Tiger Management’s investors pulled $8 billion from Julian Robertson as his bets soured in the tech bubble of 2000. Amaranth Advisors folded in 2006 after losing $6 billion on natural-gas bets. Paulson’s record since his big short has been uneven.

The money committed to hedge funds in the past decade has largely gone to multistrategy platforms. Along with Citadel and Millennium, there are other notable multistrat shops, including Point72, run by New York Mets owner Steve Cohen; Balyasny Asset Management; Schonfeld Strategic Advisors; Verition Fund Management; Eisler Capital; ExodusPoint Capital Management; and quant-oriented firms like AQR and D.E. Shaw.

While differing in particulars, the multistrat shops share essential traits. They move their capital around teams of in-house portfolio managers. There may be hundreds of these specialized portfolio managers in a single hedge fund, all sharing the platform’s infrastructure for technology, trading, data, finance, and support services. Based on the portfolios’ performance and opportunities, the top bosses add or subtract capital, levering up to press timely bets.

Old-school asset allocators can’t move as adroitly. “On any day we can swiftly pull together a team of experts across a range of asset classes from around the globe and ask, ‘What are you seeing?’” says Gerald Beeson, chief operating officer at Citadel. “We can then move immediately to respond and reposition.”

The bosses at these firms enforce risk discipline that many traditional hedge funds eschew. Portfolios are market neutral—built so returns aren’t moved by the market’s tides—and scrutinized for unintended exposure to a variety of risks. Losses are quickly cut. A 5% drawdown might stop new capital from getting allocated to a portfolio. A 10% drawdown might cost the portfolio manager his or her job.

Some platforms are more tolerant of losses than others, but a word you hear often is “Darwinian.” After a two-year hiring spree, Schonfeld’s returns slowed. When talks of a combination with Millennium broke off, Schonfeld cut 15% of its staff in November. Its main fund ended 2023 up a modest 4.8%.

Loss aversion makes multistrat managers less inclined to the heroics of some old-time hedge fund managers, who stuck by companies like Apple when they were out of favor, or spent shoe leather unmasking firms like Valeant Pharmaceuticals International —which settled Securities and Exchange Commission fraud charges over its disclosures without admitting them.

Having hundreds of portfolio managers on a platform costs money—lots of it. The multistrat shops compete for talent by offering signing bonuses and profit percentages. Strong performers can play the multistrat circuit. Balyasny partner and trader Patrick Staub, for example, came to the firm after stints at Point72 and Citadel.

“It’s a war for talent. These traders are like superstar athletes,” says Mike Karp, who heads the recruiting firm Options Group. “You have to be very mathematical, have a tolerance for risk, and a strong stomach.”

To fund their portfolio managers’ compensation, multistrat firms ditched the traditional hedge fund fee structure that charged a management fee of 1% to 2% of assets to cover expenses, plus 20% of benchmark-beating gains as a performance fee. Multistrats replace the management fee with a “pass-through” expense approach, in which investors cover most of the firm’s operating expenses. When firms spend heavily on recruitment and infrastructure, pass-through expenses can rise as high as 7%.

To cover those expenses and still reward investors, multistrat firms have to achieve strong gross returns. An October 2023 report by Barclays concluded that investors got what they paid for. Firms with a pass-through structure delivered twice the returns and a fraction of the volatility over the past three years, versus hedge funds with traditional fee structures.

The pass-through structure lets a firm make investments in talent and technology that a fixed management fee can’t cover, says David Form, a partner at Sidley Austin, a law firm that pioneered the arrangement years ago. “It’s like a sports team that can spend whatever it costs to get the best players,” he says, “versus one whose payroll is constrained by a budget.”

The Days When Multistrats Could Do No Wrong

Multistrat firms sailed through the choppy markets of recent years, as the Covid pandemic and meme madness tossed investors around.

“From 2018 to 2022, they could do no wrong,” says PivotalPath’s Caplis. In 2020, the multistrats measured in PivotalPath’s Multi-Strat Index returned nearly 13%, which was acceptable as the S&P 500 gained 18.4%. When the S&P tumbled 18% in 2022, Pivotalpath’s index of multistrats still gained about 2%.

But in 2023, that Multi-Strat Index gained only 5.4%, while the S&P 500 rose 26% and the risk-free rate of three-month Treasury bills topped 5%. The funds on the downside of that class average will have trouble retaining investors if their grades don’t improve.

The underperformers include a lot of new shops. In 2015, there were 38 multistrat firms in PivotalPath’s index (which counts only firms with more than $50 million, and a record exceeding 18 months). In 2023, there were 62. In just the past year, the multistrat shops surveyed by Goldman have grown in number by 41%.

A study by Barclays last year concluded that older, larger multistrats—like Citadel and Millennium—have better performance than their new challengers. Even among established firms, there was wide dispersion behind the group average. While AQR was up more than 18%, Balyasny returned 2.7%.

Citadel, for one, has weathered markets’ ups and downs since 1990, turning $1 million invested then in its Wellington fund into $378 million by year-end 2023. A million invested in the S&P 500 over the same span became $29 million.

Multistrat firms that have proven to be champs over many seasons are able to reinvent themselves—drawing performance from different strategies in different years.

“Five years ago, our commodities desks traded natural gas and power,” says one multistrat chief. “Today, they’re trading crude oil and weather derivatives.”