FA Alpha Daily

The herd mentality can cause huge losses

A rise in Pod Shops ushered in a new investment era using capital reserve strategies with multiple external managers. While diversifying risk across various strategies seems wise, the risk of “crowded trades” poses a threat, undermining the intended diversification benefits. Despite the appeal of stable returns and flourishing funds, concerns arise about potential market instability during downturns, exemplified in LMR Partners’ losses in 2023. In today’s FA Alpha Daily, we delve into LMR Partners’ balance between diversification and the dangers of herd mentality.

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Pod shops, also known as multi-manager hedge funds, have grown significantly in popularity and assets over the past two decades.

As the name implies, pod shops allocate capital to numerous external investment managers across a variety of strategies. By diversifying risk across multiple managers, the goal of pod shops is to smooth returns while maintaining upside potential.

Typically run by a team of portfolio managers, pod shops conduct extensive due diligence on external managers before investing client funds.

They then monitor performance continuously and have the ability to redeem capital or add to positions based on a manager’s risk-adjusted returns. In this way, pod shops aim to act as a one-stop-shop for institutional and high-net-worth investors seeking exposure to top-tier hedge fund talent.

As pod shops grew in size, some critics warned their diversification benefits could be undermined during periods of market stress.

If numerous external managers concentrate on similar positions, crowding effects may emerge where coordinated unwinding of trades exacerbates volatility.  We can see the increased correlation in returns within strategies as more funds pile into popular quantitative factors or trades.

A prime example is LMR Partners.

LMR Partners allocates capital to numerous external managers across global macro and event-driven strategies. For over a decade, the firm enjoyed strong returns managing over $11 billion in assets by late 2023.

However, LMR Partners suffered significant losses in 2023 due to crowded trades among other large pod shops.

The fund was increasingly concentrating on popular momentum trades.

Specifically, LMR Partners held large exposures to stocks in the so-called “Magnificent Seven”, including Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), and Tesla (TSLA). These positions were part of the crowded “single-stock momentum” factor pursued by numerous quantitative funds.

On days of sharp market selloffs, LMR Partners suffered major losses as these crowded quant trades reversed abruptly. For instance, during late 2023 algorithmic funds recorded outsized losses exceeding 1% as the momentum factor turned, with exposure to just a few stocks magnifying the downside.

The rapid unwind of concentrated positions across some of the largest hedge funds has raised financial stability concerns from prominent investors like Bill Ackman. They warn billions of assets managed by only a handful of players could destabilize markets if forced to sell positions simultaneously.

Regulators are increasingly investigating the growing coordination and leverage at mega-funds pursuing similar strategies. If a market shock causes rapid deleveraging, contagion between highly correlated trades held by different funds poses huge risks.

In this environment, even a well-established pod shop like LMR Partners appears unable to fully offset risks from the industry’s increasing herd behavior and interconnectedness. Continued monitoring of concentration levels across the largest hedge funds is necessary.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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