The Hedge Funds That Changed the Game

Their imitators are having trouble keeping up.

The big three’s advantage comes from having pioneered what has become the hedge-fund industry’s hottest strategy over the past few years: Known as multimanager firms, they divvy up money across as many as hundreds of specialized investment teams with the aim of producing steadier returns that are uncorrelated to broader markets. Their method turns on its head the original idea of a hedge fund as the strategic vision of just one manager.

Cohen’s Point72, Englander’s Millennium Management and Griffin’s Citadel notched returns of around 10% or more last year. That is not nearly the 26% return, including dividends, of the S&P 500 last year, but hedge funds typically don’t mark their success against the overall market. They aim to make money in any type of market environment. A broad hedge-fund index returned 7.5% last year, according to research firm HFR.

The top three’s competition, meanwhile, struggled to beat the return any investor can get by stashing cash at the bank and earning interest. Balyasny Asset Management finished up 2.7% in its flagship fund. Schonfeld Strategic Advisors gained about 3% in its main fund. Walleye Capital, founded in Minnesota, returned about 4%. London-based LMR Partners generated returns of 2.9% in its main fund.

Huge sums of money have flowed into multimanager firms in the past few years, defying what has otherwise been a period of tepid asset growth in the hedge-fund industry. Assets at multimanager funds ballooned from $185 billion at the end of 2019 to $350 billion at the end of last year, according to Barclays. Big institutional investors like pensions and endowments find them attractive because they operate more like an institution than a trading shop.

Lately, the growth has been among copycats because the top three multimanager firms have closed their doors to new capital. But few of the newcomers have been able to match the gains made by the old guard.

A large part of Citadel, Point72 and Millennium’s success has been driven by their size and the amount of money they have to deploy, investors and executives say. The biggest firms have the resources to pick off star portfolio managers with guaranteed paydays, expand into frontiers like commodities trading and invest in new technology to better manage risk and identify new and lucrative investments, according to bankers and investors.

“The leaders have an advantage," said Rob Christian, chief investment officer at K2 Advisors, a Franklin Templeton unit that invests more than $10 billion of client money in hedge funds. “They have the infrastructure, technology, data, the lines with [Wall Street], the hiring pipeline, and the risk management."

The success of the big three firms in some ways bucks conventional hedge-fund wisdom. In the old days, hedge funds struggled to replicate their returns the larger they got. Winning trades often worked well when using smaller amounts of money at a time. Otherwise, competitors quickly caught on to trading strategies.

Citadel and Millennium each manage around $60 billion, and Point72 manages about $32 billion, ranking them among the largest hedge-fund firms globally. Last year, after fees, Citadel returned 15.3% in its flagship Wellington fund, while Point72 gained 10.6% and Millennium returned about 10%. These firms don’t disclose publicly which types of investments were their winners, but Citadel posted gains on its bets on stocks and bonds, The Wall Street Journal previously reported.

The size of today’s multimanager behemoths marks a dramatic evolution from the firsthedge fund, launched about seventy five years ago when Alfred Winslow Jones, a journalist and sociologist, raked together $100,000 in seed money. His goal was simple but revolutionary at the time: By scooping up securities he thought were undervalued, while also hedging his portfolio—or selling short securities he thought were overpriced—he could make money whether the market went up or down.

Star traders who swung for the fences with concentrated bets dominated the industry in the decades that followed. Paul Tudor Jones of Tudor Investment Corp made an estimated $100 million on Black Monday in 1987, while George Soros made $1 billion in profits for his firm betting against the British pound in 1992. The 2000s brought bigger paydays, including the $15 billion John Paulson’s firm made betting against the U.S. housing market at the start of the financial crisis.

The first multi-manager firms, which emerged about three decades ago, advanced the original A.W. Jones approach. They start with a so-called market-neutral approach that aims to benefit from rising and falling markets and apply it to scores of investment teams often hyper-focused on specific sectors or securities. These teams operate semiautonomously, increasing the odds that bets will be diffuse and returns will be more stable. They are going for base hits, not grand slams.

One selling point that many multimanager firms offer investors is a focus on risk management. In the most extreme cases, performance is tracked minute-by-minute and demands can be cutthroat: Cut your losses quickly—or risk being cut from the firm itself.

“We call them the stabilizers—these are funds that have demonstrated their ability to manage risk well," said Sherban Tautu, founder of Geneva-based Ten Edges Capital, which focuses on hedge-fund investments for clients, including high-net-worth families.

“Certainly these managers can’t shoot for the moon," he added, “but they are managers from which we expect to deliver anywhere between 5% and 10% each year, with low volatility."

Many up-and-comers, several of them offshoots of the top three, have struggled in part because they haven’t been able to spread their bets widely enough. One of the advantages that firms like Citadel, Millennium and Point72 carry is their ability to run multiple investment strategies, such as macro trading or stock picking, at once. A recent Barclays survey found that multimanager firms that last year ran four or more strategies posted nearly double the returns of those that concentrated the bulk of their portfolio in just one strategy.

New multimanager startup funds this year will test investors’ interest in these types of hedge funds. Sizable new launches are on the way from Fortress Investment Group, former Millennium Asia Co-CEO Jonathan Xiong, and Robert Kim, former chief investment officer of AllianceBernstein’s multi-manager offering.

Bobby Jain, Millennium’s former co-chief investment officer, plans to launch a multimanager firm, Jain Global, in July. To attract investors, Jain has cut performance fees for those who signed on by a certain date or committed certain amounts of money, with the steepest discounts available for investors who committed at least $250 million, said people familiar with the matter. Having a class of early investors with perks like that is common.

Part of the allure of setting up new multimanager funds stems from the higher-than-usual fees they are able to charge. Instead of the traditional “two-and-20" structure where investors were charged 2% of fund assets and 20% of any profits generated, multimanager firms charge investors the costs of running the funds, such as signing bonuses and technology.

Under this so-called pass-through fee model, investors on average pay expenses equivalent to around 5% of fund assets, plus performance fees, according to a Barclays investor survey. In some cases, expenses can amount to more than 7% of assets, the bank found.

Multimanager firms also typically ask investors to keep their money locked up for longer. At Millennium, for example, it now takes investors five years to fully extract their money from the firm, once they decide to withdraw it.

Marlin Naidoo, who facilitates introductions between investors and hedge funds as the global head of capital introduction at BNP Paribas, said that because demand for the strategy was so voracious for the past few years, investors had little leverage to push back against the terms multi-managers commanded.

Things are starting to change, Naidoo said, especially as the upstart firms have failed to match the performance of more established players.

“We’re potentially at the stage where the power balance is not necessarily with the investor, but it’s evened out," Naidoo said.

Write to Caitlin McCabe at caitlin.mccabe@wsj.com and Peter Rudegeair at peter.rudegeair@wsj.com