A team of strategists at Verdad successfully replicated the performance of so-called 'pod shops' using a collection of actively managed ETFs and mutual funds available to any investor
One of the hottest stories on Wall Street over the past few years has been the rise of so-called "pod shops."
These sophisticated hedge funds hire dozens, and sometimes hundreds, of individual portfolio managers. Each is handed a pot of money and tasked with pursuing their own investment strategy.
Individual managers invest their money more or less independently. The only coordination happens at a firm-wide level, where sophisticated models are employed to protect the fund from being too exposed to any one style of risk.
Managers who perform well are rewarded with more money and bigger paydays. Those who perform poorly see their allocations reduced, or are eventually let go.
In aggregate, returns for these funds haven't been all that impressive. According to Hedge Fund Research's multi-manager pod-shop performance index, global pod shops have returned 7.4% so far in 2024 on an equally-weighted basis, net of fees.
But some have boasted astronomical returns, helping to inspire a legion of imitators over the years. For example, Citadel's flagship multi-strategy fund delivered average net returns of 19% beginning in the early 1990s through 2022, according to a report from Risk.net.
This helped piqued the interest of a team of strategists at Verdad Advisers.
According to a report shared with MarketWatch on Monday, the Verdad team said it set out to mimic the returns achieved by these sophisticated investors while relying solely on the more than 3,000 actively-managed ETFs and mutual funds. Turns out, they were successful.
As the chart below shows, the Verdad team's leveraged "public pods" strategy would have dramatically outperformed both the S&P 500 SPX and a 60-40 portfolio of global stocks and Treasurys since 2000. Furthermore, despite employing substantial leverage, the team managed to keep the additional volatility to a minimum.
The unlevered version of the strategy may have trailed the S&P 500, but it did so with far less volatility.
Their findings suggest that maybe there is hope for active managers aiming to consistently beat their benchmarks. Over the past decade, investors have shifted billions of dollars away from active managers in favor of cheaper passive funds that track a benchmark like the S&P 500.
"The core thing that we're trying to argue here is, first, you need a lot of active managers. You can get them by hiring them yourself, or investing in these actively managed funds," said Dan Rasmussen, a founder and portfolio manager at Verdad, during an interview with MarketWatch.
"And second, you need a good risk model. These risk models are a common tool used by quantitative investment managers. Every quant fund tends to build their own," he added.
During their research, the Verdad team collected return data from a universe of more than 3,000 actively managed funds. Then, they tried to identify how much of each funds' return could be reliably attributed to the manager's skill.
After ranking these funds on the basis of how much "alpha" their managers had generated over the past 12 months, the Verdad team found that to keep its strategy competitive, it needed to rebalance its holdings regularly to account for the difficulty in generating consistently strong alpha over time.
Verdad's findings also helped shed some light on what has really driven pod shops' performance, Rasmussen said.
"We think it's possible that the pod shops are succeeding not just because they have access to exceptional talent but because of their disciplined execution. It's possible that their edge lies in dynamic capital allocation to short-term alpha generators, rigorous risk management using advanced risk models, and the strategic use of leverage to amplify returns," he said in the report.
The upshot: Replicating pod shops' secret sauce is a complicated endeavor. But it can be done using only publicly-traded ETFs and mutual funds, likely at a fraction of the cost.
"If those are indeed the core building blocks in the model, there's no reason it couldn't be re-engineered using the thousands of public managers plying their trade in liquid funds," Rasmussen added.
U.S. stocks were mixed on Monday, with the S&P 500 and Nasdaq Composite COMP rising, while the Dow Jones Industrial Average DJIA declined.
-Joseph Adinolfi
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