A wild start to the year: cruising through market mayhem

An uncomfortable start, to say the least!

From my conversations with top fund managers, I learned one thing: It is not about having great insights. Many investors can spot good opportunities. The real differentiator is the discipline to follow through and having a robust process.

And that process signaled trouble in December. While many now say that tariffs are the root cause of the sell off, I would argue they are merely a catalyst. The macro chamber has been filling with gas for a while now, waiting for a spark. Below the graph where you can see the moment we stepped out of the market.

In the graph above, we also see the spread on U.S. high yield, which is at historical lows and is now starting to correct. This spread includes the priced default probability. Keep a close eye on this because, in my opinion, the probabilities of default priced in by the corporate credit spreads (<350 bps) still reflect a swift recovery in the market. Therefore, if this section of the market starts misbehaving, we might be in for more trouble.

As said, in the U.S., credit spreads are still at historic lows, and prices remain stickier than expected. Last week we had some positive surprises on inflation, with continued pressure from the core services sector, and shelter as a clear pain point. We also have historically loose financial conditions, volatile growth forecasts, and term premia still reflecting heightened market uncertainty. On top of that, the administration aims to manage the budget balance by taxing the lower echelons of society-the very group with the highest propensity to spend-through tariffs. This same consumer is doing the heavy lifting in the U.S. economy. The challenge is clear: a strong dollar typically follows high yields, driving up refinancing costs for the government, while lower yields are often paired with a weaker dollar and increased tariff burdens on consumers. The market has shifted its fears to the first scenario to a cool down of the US economy and a weaker dollar, the latter scenario.

Still this cocktail of forces leaves little room for anything other than a rotation and if it continues a correction. Now, imagine an alternative policy scenario—a coordinated pro-growth agenda. In that case, real yields would rise, SOFR-treasury spreads would widen, and the 1-year forward 1-year inflation swap would increase. Markets would grow scared and sell, in fear of overheating. With treasury yields reaching 4.8%, driven by real yields and term premia, this scenario mirrors the market fears we observed just two months ago.

Real yields are once again at the center of market action, albeit in reverse, with some signs of inflation expectations easing further. We’re witnessing a stagflationary rotation in markets, where the broader macro backdrop leaves policymakers with little room to maneuver—sticky prices continue to play a crucial role. While it’s not yet a real flight out of risk, this scenario remains a possibility. The labor market has held up well so far, but much of what we’ve seen over the past weeks are yet to be reflected in the data.

Progress in bringing down prices has been slow—perhaps too slow. By definition, a soft landing means preserving growth, yet over the past year, maintaining growth has gone hand in hand with persistently sticky prices. The question remains: can policymakers navigate our complex economy precisely enough to overcome inflation without triggering an economic slowdown? The market fears that the answer is no.

Looking ahead, signs of economic downturn can provide central banks space to react. For example, if/when the FED signals a quantitative tightening cycle pause this week, we could see additional liquidity entering the market. Still, the broader macro-economic environment remains challenging. Sticky prices, government policy being uncertain and volatile growth continue to complicate the landscape. Adding to this uncertainty are the varied opinions within the Fed, which further cloud the outlook. We remain largely underexposed, and are fine with stepping in later.

While macro uncertainty dominates the headlines, another trend is reshaping the investment landscape.

I recently hosted a roundtable discussion on the rise of multi-manager platforms, joined by very smart managers and allocators. We took a deep dive into this world.

Three key aspects that I would like to highlight:

• The effect on the fund management industry

• The perspective of the multi-manager platform

• The manager perspective

The effect on the fund management industry:

In my opinion the multi-strats have brilliantly reinvented the fund-of-fund (FoF) model into a pod-model with two inventions:

1. By insourcing the manager, the multi-strat effectively removes direct access for LP’s and FoF’s. This means that LP’s have to pay the multi-strat’s fees, and those tied to its internalized pods—known as pass-through. In 2024, investors paid between 5-8% in expenses for full pass-through access. Generally, LP’s get around 50% of the returns and even about 20-30% of the alpha. So secure the pod and clip the alpha. While the fee structure is better understood these days, it remains much more opaque than the traditional FoF model. LP’s got fed up with the double fees of FoF but seem to have once again fallen for a similar model

2. They have and continue to push the envelope on superb risk management—especially tail risk management. No matter the style of investing a manager adheres to, risk is always present, and the key question remains: Am I being compensated for it? For me, two important sources of risk are volatility and tail risk, as investors typically choose one or the other. For example, if you leverage high Sharpe RV trades, you have two important sources of tail risk: the short leg and the high levels of leverage. But you see a much smoother return profile. Hence, the tail risks are usually not visible in the same way volatility is, and only show in tail scenarios, if the risk management fails. These multi-manager platforms focus (for the most part) on low-volatility, high-tail-risk strategies—and so far, they’ve demonstrated a fantastic grasp on tail risk management. Both through hedging most exogenous factors as well as having tight limits. This allows them to directly manage the pods, and redistribute capital across managers/pods based on their risk.

Then there are some trends in the industry. One of them being the illiquidity trend. This is driven for a large part by the desire to secure more favorable terms from prime brokers. However, it puts liquid single managers and smaller liquid multi-strategy funds at a significant disadvantage when a liquidity event occurs. Sometimes, these more liquid funds can then serve as the "ATM".

Two important takeaways from all of this is:

1. All the piling up of tail risk does increase the macro risk of a systemic liquidity event.

2. For LPs, it’s increasingly frustrating to be locked into a liquid asset class that’s structured with long lockups, such as five-year lockup terms. In fact, over 30% now require lockups of more than two years.

The perspective of the multi-manager platform

One of the biggest challenges these platforms face is sourcing high-quality pods. To maintain their performance, there’s a constant need to source top-tier talent.

This challenge varies depending on whether you're talking to a more specialist multi-strat or other larger, well-known firms, but the fundamental issue of the decreasing ability to source high-quality pods remains across the board.

Recently, the opportunity set for sourcing pods has been shrinking. As pod managers gain more pricing power, they’re less inclined to integrate. And many multi-manager platforms have been allocating externally as well.

The manager perspective

As a manager, there are several factors to consider when deciding whether to become a pod or continue operating as a single shop. For me, the most important factors are investment style and whether you simply want to run a strategy or are also interested in building a business.

Generally, there’s no such thing as a free lunch. You’re faced with a tradeoff: you can consume volatility, keep leverage conservative, reduce your tail risk, and that way you still deliver a 2-sharpe-high-return strategy. Alternatively, you consume leverage and tail risk to pursue a low-volatility, high Sharpe strategy. The latter is preferred by multi-manager platforms, as their centralized risk management manages the various sources of risk as a second line of defence. This enables them to leverage small, idiosyncratic return components.

For managers then, an important choice is to have to optimize their strategy for the type of risk they want to take. Personally, I like to give some of my investment theses some oxygen, and that's how we have designed our systems.

As for the ambitions of a manager, there's the tradeoff between being a specialist investor or being someone who runs a strategy and is also building a business, brand, and raises capital. Fundraising is incredibly challenging, regardless of how strong your strategy is and these platforms offer capital in return for captivity.

Finally, there's the matter of non-competes. Some of these can be very restrictive.

Originally Published On (18-March): https://www.linkedin.com/pulse/wild-start-year-cruising-through-market-mayhem-reza-kahali-uwuac/?trackingId=JkRvTXWfSMCSOm8oq7LVmA%3D%3D