A Brave (and Risky) New World: The Gig Economy Comes for Hedge Funds

Hedge funds exert outsized influence on financial markets because they employ aggressive trading and high leverage. The world learned this in 1992, when George Soros broke the Bank of England – and again in 1998, when Long-Term Capital Management almost broke the global financial system. The failure of Amaranth in 2006 roiled energy markets, and the failure of two of Bear Stearns’ subprime mortgage funds were the canary in the coal mine for the 2008 financial crisis.

On the other hand, hedge funds provide liquidity and push prices into arbitrage relations, enabling better alignment with economic reality. So, risk managers value hedge funds for smoothing financial markets and reducing volatility, but also fear them triggering or amplifying risk.

This is why recent trends in the hedge fund industry are both intriguing and worrisome.

Aaron Brown

On the heels of its explosive growth in other industries – including ride-sharing services, general services companies and do-it-yourself real estate rentals – the gig model is now the fastest-growing segment of the hedge fund industry. Successful managers, instead of starting their own funds or working for multistrategy funds, set up their own LLCs, which contract with multiple platforms as well as some investors directly. This should foster more competition, more technological innovation and more stability while potentially yielding lower costs and delivering greater freedom to both investors and managers. But this trend ultimately may also result in inferior risk management.

Managers do not have to choose between the risk and trouble of starting their own funds versus the restrictions of working for an asset management company. The gig platform provides many of the centralized services and some of the security of having an employer, while leaving managers the freedom to grow their own businesses on the side.

On the investor end, a gig platform offers access to many niche and new managers who would be difficult and expensive to find if they were running independent funds – or whose alpha would be buried as employees of large multistrategy funds. The gig platform, moreover, can provide rigorous manager selection, offer extensive performance oversight, and enforce tight financial and risk controls, without the expense of fund-of-funds.

However, as more and more hedge funds move toward a gig approach, more risks will emerge. And while gig managers may have a good sense of trading risk, they typically will not have the specialized knowledge to plug into marketwide best practices to manage systemic risk.

Traditional Funds vs. the Evolving Gig Landscape

In the hedge fund industry, the gig trend is being driven by inexorable economics. All net-new investment in hedge funds is going to multi-manager funds, with the rest of the industry flat or shrinking.

Single-strategy hedge funds cannot compete for talent with what the gig platforms can offer. The best managers want the freedom to run their own business, with the convenience and security of working through an established large platform.

Another strong appeal of gig work for the best managers is that it provides them with the ability to keep the full performance fee earned on individual performance. To be paid well as an employee in a large hedge fund, you typically need both good personal performance and good firm performance. As the long as the firm does well, though, you can be paid a comfortable amount and keep your job for a while even if your performance is poor. But the best managers and the biggest risk seekers prefer to be fully compensated for personal performance regardless of the firm’s results.

While there are no pure gig hedge fund platforms today, nearly all big multimanager hedge funds except Citadel –including brand names like Millennium, Point72, BlueCrest, Balyasny and Schonfeld – employ some external managers. Some of these external managers are allowed to take outside money, but even the exclusive managers find it easy to switch platforms or set up as independent funds.

Well-received startup ClearAlpha Technologies has moved closest to the gig model. Its first offering is a commingled fund apportioned among its managers, but its platform can match investors to individual managers or to a customized portfolios of managers, cutting out all the expense of intermediaries.

To understand how we arrived at this stage, it’s important to remember the history of traditional funds and to explain how they have evolved.

Most of the great 20^th century hedge funds were founded by people with dicey resumes, distinguished more by independent thinking and varied careers than by prestige degrees, conventional financial expertise or previous job titles. These are the funds that transformed financial markets and produced extraordinary returns, as well as the funds with the most spectacular blow-ups. A lot of modern financial risk management developed in response to those disasters, and large institutional hedge funds today have some of the most sophisticated and extensive risk management systems in place.

Things started to change when the hedge fund business transitioned into the alternative asset management business, with mainly institutional money and heavy regulation. The best funds became too large to chase new niche, low-capacity strategies – or they closed to outside money to stay in the low-capacity game.

Unlike the boom-or-bust earlier ventures, many funds were started by people with established financial credentials. The startup costs of new hedge funds subsequently rose to levels few independent outsiders could pay.

Today, it can be hard to tell the difference between a large hedge fund with multiple products and a traditional asset management company.

Pros and Cons of Gig Funds

The promise of gig hedge fund platforms is to open up the alternative asset management game to a wider variety of competitors, and to offer investors more direct access to niche and new strategies, at lower cost. This approach can provide opportunity to independent thinkers, without the hurdles of either starting a fund on their own or getting jobs with established funds and rising to a level where their ideas can be implemented.

Another effect of gig work is to stabilize hedge fund strategies. Traditional hedge funds have long lock-ups and notice periods for redemptions, allowing them to stick to long-term strategies through unfavorable markets. The non-gig multistrategy funds, on the other hand, are known for yanking capital quickly after losses, meaning the smartest and most aggressive money can suddenly disappear from strategies and asset classes.

Gig managers have more staying power, because each manager is pursuing a single strategy and has no alternative places to put money. On the downside, gig hedge fund managers are not known for independent risk management. External managers typically rely on the multistrategy fund for risk management – but as external managers get more independence and transfer to gig attitudes, independent professional risk management is likely to be neglected.

Parting Thoughts

No one has yet demonstrated that a hedge fund gig platform can attract the best new managers, nor deliver superior returns at lower cost to investors. Moreover, no one has even opened a pure gig platform; all existing funds rely at least in part on employee-managers.

But don’t overlook the tremendous appeal of gig work. An estimated 75 million Americans have done at least some gig work. Many of them are really traditional freelancers, or people who would prefer regular full-time employment but are treated as contractors for the employer’s convenience, or people who take on occasional (casual) gig work for a little extra money.

That still leaves millions of full-time gig workers, who take advantage of multiple platforms and opportunities for gig income while building their own independent businesses on the side.

If the next generation of hedge fund managers arise via gig work – rather than, say, traditional Wall Street jobs or their own startup businesses – the economy’s march will be led by people with a different type of mindset.

Consequently, 30 years of progress on professional independent risk management of the most aggressive and highly-levered investors could be lost. Risk managers must therefore be alert for changes in market trading conditions, as well as the potential for new kinds of blow-ups.

Aaron Brown worked on Wall Street since the early 1980s as a trader, portfolio manager, head of mortgage securities and risk manager for several global financial institutions. Most recently he served for 10 years as Chief Risk Officer of the large hedge fund AQR Capital Management. He was named the 2011 GARP Risk Manager of the Year. His books on risk management include The Poker Face of Wall Street, Red-Blooded Risk, Financial Risk Management for Dummies and A World of Chance (with Reuven and Gabriel Brenner). He currently teaches finance and mathematics as an adjunct and writes columns for Bloomberg.