The hottest fund today, the "ultimate answer" to investing?

Earning more, with less fluctuation - this may be the biggest wish of every ordinary investor. In finance, there is a specific indicator to measure this: the Sharpe Ratio. The algorithm basically subtracts the risk-free rate from the investor's returns, and then divides that number by the standard deviation of the returns (which represents the volatility). The Sharpe Ratio measures how much excess return each additional unit of risk taken in investments generates. In other words, it's not just about earning more, but also about considering how much risk you are taking. Whether it's Buffett or Munger, their success is enviable, but most people cannot withstand the pain of their net worth being halved like Munger. The pain caused by a market crash is often greater than the joy of a market boom. "Steady happiness" is the pursuit of most people, even professional institutions like pension funds and retirement funds cannot accept large fluctuations. However, there are funds in the market every year that make huge profits, but few can provide high Sharpe ratios in the long term. The most profitable hedge funds, unlike what you think In January 2023, after the annual ranking of hedge funds released by LCH, the media exclaimed, "The king of hedge funds" has changed hands. Ray Dalio's Bridgewater Fund had long held the title of the world's most successful hedge fund, but this time, it was surpassed. Taking the throne of "hedge fund king" was Ken Griffin and his Citadel Fund. According to LCH's data, Citadel made an amazing $16 billion for clients in 2022, and has accumulated $65.9 billion for clients since its founding in 1990, surpassing Bridgewater Fund's accumulated profits of $58.4 billion since its founding in 1975. How amazing is Citadel's performance? In 2022, the US market experienced a double hit in stocks and bonds, with the Nasdaq index sharply falling. The previously brilliant Tiger Fund all suffered defeat in that year, with the well-known tech stock fund Viking losing a huge $3 billion, the most profitable fund in 2021, TCI, losing $8.1 billion, and even the "little Buffett" Seth Klarman's Baupost losing $1.5 billion. Citadel made $16 billion in that year, breaking the record of $15 billion made by Paulson in the 2007 subprime mortgage short, which was called the "greatest trade in history." In 2023, the US stock market eventually surged under significant volatility, and Citadel still made $8.1 billion, continuing to expand its lead on the hedge fund rankings. Despite its amazing profits, what sets Citadel apart is its strong Sharpe performance. For example, in the year when the US stock market finally surged in 2023, Citadel's return rate was 15.3%, seemingly far lower than VOO's 24.2% for the S&P 500 ETF, but looking at the Sharpe performance: Citadel's Sharpe ratio was as high as 2.51, far exceeding VOO's 1.09%, because the volatility that year (represented as a standard deviation of 4.50% in the article) was much lower than VOO's 18.51%. This means that the return on each unit of risk taken by Citadel significantly outperformed the US stock market benchmark index, making it the highest Sharpe ratio for VOO in over a decade. Citadel's ability to ignore market fluctuations, refuse withdrawals, and continue to profit in 2022 and 2023, two tumultuous years, is truly remarkable. This completely subverts investors' perceptions of the hedge fund industry, and in a subsequent report, the Wall Street Journal directly stated that Citadel has reshaped the hedge fund industry. What is the impression of hedge funds in people's minds? The initial emergence of hedge funds was marked by George Soros's defeat of the Pound, Julian Robertson and his Tiger Fund's dominance in tech stocks, and John Paulson's big short during the financial crisis. These star managers are known for their concentrated bets after spotting trends, and their moments of glory are so dazzling that many funds flock to them. However, star funds are not necessarily "friends of time," but rather "despondent originators." After the hedge fund Amaranth Advisors lost a massive $6 billion bet on natural gas and collapsed in 2006; Julian Robertson, the godfather of the Tiger Fund, suffered huge losses in the dot-com bubble of 2000, with investors withdrawing up to $8 billion; John Paulson's performance was erratic after 2008, lacking the magic he had before; even George Soros, as wise as he was, eventually returned all external funds. Investors licked their wounds clean, realizing that even masters cannot be trusted for a lifetime, and that "eggs should not be put in one basket", followed by the emergence of hedge fund of funds (FOF). FOF painted an appealing picture for investors. They charged certain fees, found the best hedge fund managers globally, integrated them into a diversified, unrelated, and high-return investment portfolio, monitored their performance, and occasionally removed the weakest funds from the portfolio. In 2009, the "largest Ponzi scheme in history," Madoff, collapsed, shocking investors and revealing that some of the largest FOFs were involved. These FOFs charged high management fees, but stumbled upon the largest pitfall. Both "single-manager funds" managed by star geniuses and seemingly attractive FOFs failed to bring investors "steady happiness". Ironically, the emergence of hedge funds was intended to solve investors' problems. The first hedge fund was established about 75 years ago when journalist and sociologist Alfred Winslow Jones raised $100,000 in seed money. At the time, his goal was simple but revolutionary: buying undervalued securities while hedging the portfolio by short-selling overvalued securities. This way, he could make money regardless of whether the market went up or down. Over 70 years later, despite occasionally impressive performance by hedge funds, they have still struggled to satisfy investors.Je suis dsol, je ne parle pas en espagnol.The bleak reality has kept a whole generation of investors away from hedge funds, especially after 2008, when the hedge fund industry was almost the only one stagnating or even shrinking among all investment industries. This situation began to gradually change in 2017, with a fund called "multi-manager strategy" seeming to really achieve "low market correlation, stable and sustainable excess returns (Alpha)". The most typical representative is: Citadel, founded by Ken Griffin. Citadel: Investing like building a car! Ken Griffin's life seems to be powered up. Griffin was born into a family of serial entrepreneurs, with his father in the construction materials industry, and the largest employer in the town being IBM. The perspective of entrepreneurship and technology played a crucial role in his future development. Griffin's dream since childhood was to make big money. Starting in high school, he taught himself programming and started a consulting company. His investment career began with buying two put options while studying at Harvard. This trade made him $5000, but more importantly, it struck him that the price at which he sold the options was lower than the theoretical fair value, and the brokerage firm was able to make risk-free profits through arbitrage. Although he made money, being "cut off the leeks" by others, Griffin couldn't stand it. He then switched to study mode, teaching himself various asset pricing theories, including options pricing. By chance, he found an arbitrage opportunity in convertible bonds. In his university dormitory, he raised his first fund and officially started his investment career. Ten years later, in 2001, at the age of only 33, Griffin had never worked at any Wall Street institution after graduating, but he managed to establish one of the top five hedge funds globally, with Citadel's asset under management reaching $6 billion. Citadel's flagship fund, Wellington Partners, had an average annual return rate of 30.01% in the previous decade, and the net annual return rates of the other four US and offshore funds were astonishingly stable, ranging from 19.44% to 28.8%. In the past ten years, Citadel's funds only made losses in 1994, when Wellington dropped by 4.3%. At this point, Citadel had already demonstrated its uniqueness: While Soros, Paulson, and others were great fund managers, Griffin was different. He was not just a fund manager but also a CEO. From day one, Griffin's goal was to build the best trading company. Although he was a top-notch trader himself, he withdrew from trading early on and devoted himself entirely to Citadel's business management and infrastructure development. The core philosophy of Citadel is "Process," and Griffin's philosophy is to learn from Toyota's "lean manufacturing," transforming the investment process into modules similar to an assembly line. Unlike typical hedge funds that focus on trading talent, Griffin hired a large number of management talents to improve each "process" of the company and even invited management consulting giants like Boston Consulting to analyze all elements to improve the investment process. As early as the 1990s, Citadel heavily invested in building data and technological infrastructure to enhance automation at every stage. For every "process" of a fund management company, whether it is establishing a capital structure or improving investment methods, Citadel's goal is to "quantify and quantify something. Remove human factors as much as possible." Wall Street's evaluation of this approach was: "Citadel's R&D and planning process is more like a well-functioning manufacturing company than a fund management company". With the support system of this "lean manufacturing," Citadel had the ability to expand its territory, and Griffin demonstrated another strong ability: recruiting talent. In 1994, Citadel expanded from its origins in convertible bond arbitrage to statistical arbitrage; in 2001, it ventured into long-short equity; in 2002, it entered commodity investments, and so on. With the addition of one strategy after another, Citadel no longer resembled a traditional hedge fund. Traditional hedge funds typically focused on a single type of trading, while Citadel's rare ability lay in expanding new strategies. During the period of expansion, Griffin remained very cautious about risks. In addition to optimizing risk control processes, Griffin always attached great importance to major crises. After the news of the bankruptcy of the famous Long-Term Capital Management (LTCM) in 1998, he flew to LTCM's office to understand the details. The substantial preparation and strong financial strength made Griffin a big winner in many crises. When LTCM went bankrupt, Citadel bottom-fished for bonds; after Enron's bankruptcy, Citadel acquired Enron's most valuable energy trading division; in 2006 and 2007, Citadel acquired numerous assets at low prices during the difficulties of Amaranth and Sowood, two hedge funds. However, in 2008, Ken Griffin and Citadel took a big hit. After the collapse of Bear Stearns, Griffin and his traders rushed in to buy a large amount of investments they believed were undervalued, most of which were in the financial sector. This time, he miscalculated. The scope and impact of this crisis far exceeded his expectations. The paralysis of the entire financial market and the subsequent ban on short selling caused Citadel to lose a whopping $8 billion and forced it to suspend investor redemptions. Looking back on the experience, Griffin said: "We lost half of our investors' capital in 16 weeks. In the previous 20 years, we had never experienced double-digit losses. However, we lost half of our capital in 16 weeks." The performance chart of Citadel from its inception to 2022 is shown below, with only two annual losses, in 1994 and 2008. This historic financial crisis completely transformed Griffin, prompting him to stress the importance of risk management.To:Citadel is no longer what he calls a "storage company," they no longer buy "if we think an asset is cheap and will create value for us over time, we will buy it and provide it with funds." Now, "we are in the moving business. Therefore, unless we have very clear reasons to believe that the assets we own will appreciate quickly, we will not do so. And, we are transitioning our business from asset-intensive to - in a sense - all skill-based businesses." "Will Netflix's subscription numbers exceed expectations this quarter? Will Amazon's AWS cloud revenue exceed expectations? Nowadays, everything Citadel does is based on skill and fundamental investment decisions. This is different from before 2008 when we focused on asset-intensive businesses. Citadel's approach is: to minimize the correlation with the market as much as possible, focusing on exploiting excess returns. Ten years later, the new multi-manager fund has emerged! Multi-Manager Fund - Alpha Factory Goldman Sachs defines the multi-manager model as follows: A multi-manager hedge fund strategy is based on allocating capital to multiple portfolio managers ("PMs" or "teams"). PMs manage this capital independently of each other and are usually compensated based on their performance rather than the total results of all PMs. Large multi-manager companies may have 100 or more PMs, while smaller companies may be more concentrated, although having a few PMs is not uncommon, as PM diversification can lead to significant returns. The PMs of these companies usually have specialized expertise, such as trading specific stock market sectors, arbitraging mergers and acquisitions, or trading interest rates in a specific way. The strategies the PMs typically implement focus on generating consistent alpha while limiting beta and maintaining a low correlation with the broader market. Multi-manager platforms also typically adopt strict portfolio construction and risk management frameworks aimed at ensuring that the portfolios managed by PMs fit their expertise and also help to limit any negative impact of any single PM on the entire portfolio. Multi-manager funds typically use leverage to amplify the alpha generated by each manager. Goldman Sachs estimates that multi-manager funds typically use leverage of around 5.3 times on average. To some extent, multi-manager funds are somewhat similar to FoF, with over a hundred PMs independently managing positions, but each PM is required to maintain market neutrality as much as possible. Above the portfolios of each PM, there is a considerable "center position" that can hedge concentrated positions or increase high-potential trades. PMs of the center position may sell stocks held by multiple PMs as a hedge, or increase positions of PMs they believe may perform well, usually without their knowledge. Risk management is at the core of multi-manager funds, with strict management of drawdowns for each PM, and in the most extreme cases, performance is tracked minute by minute, with potentially very strict requirements: quick stop-loss - otherwise there is a risk of being laid off by the company. In this fund, multi-manager funds turn themselves into an Alpha factory: each PM and their team are independent workshops digging for Alpha, and then adjust these Alphas at the fund level through the management of the central position. Since 2017, multi-manager funds have shown lower correlation and strong Sharpe performance. Over the past five years, multi-manager hedge funds have outperformed a wide range of hedge funds and multi-strategy (non-multi-manager) funds, producing higher returns with significantly lower volatility and stock correlation. Making more, less volatility, and even less correlation, investors open up the Shanghai New World! AUM of multi-manager funds has grown by 175% from 2017 to 2023, while other hedge fund sectors have grown by 13% during the same period. In fact, multi-manager platforms dominate hedge fund fundraising. According to major brokers' estimates, there are only about 40 such multi-manager platforms globally, with assets under management of around $300 billion, accounting for 8% of the total $4 trillion hedge fund industry. Led by Citadel, the five giants make up the top camp of multi-manager funds: Among them: Millennium, founded by Izzy Englander, is Citadel's old rival, both established almost at the same time, with similar management scales. Another giant is the renowned Steven Cohen with his Point 72. After transitioning to multi-strategy, the "Jordan of the hedge fund world" has also performed excellently, growing rapidly, and is now one of the top three multi-strategy giants alongside Citadel and Millennium. Multi-manager funds have absorbed the vast majority of fundraising in recent years, with top platforms taking in most of the funds. Even most giants no longer accept new funds, returning profits to investors instead. This makes investors settle for second best, chasing after second-tier funds or new funds separated from the giants. As investors compete for shares of these funds, they also worry about the next risk. The primary concerns are crowding and high leverage. Due to the similar models and strategies of multi-manager platforms, their positions are very similar, combined with extremely high leverage. As mentioned earlier, with $300 billion in assets under management and an average leverage of 5 times, there is approximately $1.5 trillion in huge funds invested in very similar positions. Of course, with the risk control level of giants like Citadel, this may not be a major issue, but if a smaller, more capable multi-strategy platform blows up, will it trigger a chain reaction in the entire industry? In March 2020, the United States was hit by the epidemic, and the U.S. bond market experienced a rare liquidity shock, which ultimately forced the Federal Reserve to intervene with unlimited bond purchases to rescue the market. Behind this huge shock, including Citadel and other multi-manager funds, were accused of causing the paralysis of the U.S. bond market due to their massive "Treasury bond basis trades." Recently, the U.S. stock market...In terms of performance, giant companies like NVIDIA and Meta often experience fluctuations of more than ten percentage points after their financial reports, which is also influenced by the strategies of multiple management platforms.Next is the high cost. In order to attract larger amounts of funds and with limited Alpha in the market, "Alpha factories" must invest huge costs in infrastructure and talent competition. Platforms implement "Darwinism" internally, with strict survival of the fittest. Traders compete for centrally allocated capital. If performance is poor, your allocation may be cut or you may be fired. Those who perform exceptionally well can manage more assets and earn returns of about 15% to 22%. This is a brutal elite system, some call it a "meat grinder". As for external talent, platforms spare no expense. Signing fees of 10 to 15 million US dollars are not uncommon, and guaranteed amounts may reach tens of millions of dollars. These fees usually include advance payments to compensate for forfeited bonuses and two years' worth of guarantees, regardless of whether the employee can last until the end, these guarantees will be paid. Executives from large investment banks such as Goldman Sachs and Morgan Stanley privately admit that they cannot compete financially with these platforms, while competitors of traditional hedge funds complain that their hiring frenzy has pushed up talent costs across the industry. Who bears such high costs? The answer is investors. Ken Griffin set a benchmark for the industry a long time ago. Citadel adopts a so-called "through" fee method, where they do not charge the traditional hedge fund's 2% management fee, but transfer all operating costs of the fund to investors. According to Barclay's calculations, Citadel's annual fees could be as high as 7%. Investors love and hate this, even after deducting these high costs, platform funds have had outstanding performance in the past few years, especially the giants. And these high investments have created a very high competitive threshold, making investors worried that new platform-type funds cannot compete with these giants. The evolution of hedge funds and "the answer to investment" In fact, the high cost input and years of "arms race" have resulted in industry differentiation. Balyasny said in an interview in July, "This is a very difficult industry to establish and maintain an advantage in. The DNA of such companies is that besides being an excellent investor or trader, you also have to be good at personnel management, recruitment, infrastructure, risk, and technologystarting from scratch, it is difficult to compete in today's world." This was particularly evident in 2023, when the US stock market surged and risk-free returns represented by US bonds reached as high as 5%. While Citadel and Millennium's giants still had excellent performance, even smaller companies could not outperform money market funds. By the end of 2023, Balyasny Asset Management and Schonfeld Strategic Advisors had risen by 2.7% and 3% respectively. Goldman Sachs' report stated, "In 2023, the average return for multiple manager funds was almost the same as the risk-free rate of that year." The performance of the entire industry was mediocre, and with top funds like Citadel not accepting new capital, investors have withdrawn funds for the first time in seven years. In the 12 months ending in June, multi-manager funds experienced net outflows of over $30 billion, the first time they have faced net outflows since 2016. Looking back at the development of the hedge fund industry since its inception, Balyasny sees similarities to private equity (PE): "Thirty or forty years ago, there were thousands of PE companies," he said. "But today, the vast majority of Alpha in this industry comes from six or seven companies. I think hedge funds are very similar to this. Nowadays, it is very difficult to start a PE firm and compete with Blackstone, KKR, and Apollo. I think multi-manager funds are the same." After 35 years, Ken Griffin has gone from a Wall Street prodigy to the king of hedge funds today. Has the "Alpha Factory" he personally explored found the ultimate answer to investment? This article is translated from "Wall Street Observer", author: RiskChase; GMTEight editor: Liu Xuan.