Can you mirror the world's most successful hedge fund?

An attempt to peer above the Citadel walls.

Published on March 15, 2023

Data-crunching hedges’ shorts
(And the limits thereof)
Lots of idea-generating content…

Hedge funds are some of finance’s most fascinating beasts. For one, their strategic diversity makes for a broad church. Portfolios range from the esoteric (think trades based on satellite images of ports, or bonds’ legal fine print) to long-only equity mandates (ordinarily, FTSE 100 constituent Pershing Square (PSH)). What they share is an ability to convince sophisticated investors to commit their cash for years, and a reputation for attracting some of the sharpest minds in finance, who are paid megabucks to cook up trades no-one else has thought of.

That final quality makes them a good topic of discussion for an ideas-focused investment magazine. And yet we rarely write about them. One reason for this is transparency. Because they are usually private, hedge funds aren’t subject to the same disclosure requirements as investment trusts or listed equity funds. Some hedge fund managers share their insights with investors and clients, and some do this regularly. But in a world where informational edge and trading secrecy is everything, talking a lot isn’t always a smart move.

Another reason hedge funds’ trades can be of limited value to retail investors is what they involve. Although the sector regularly deals in liquid markets, hedgies’ edge is often found in the corners of markets where illiquidity or informational asymmetries create uncorrelated, outsized or positively skewed returns. If you lack the ability to make said trades – let alone insights into why they are being made, or the price information they depend on – then copy-trading simply isn’t an option.

These dynamics are exemplified in what is the biggest and most successful hedge fund today, Citadel LLC. Last year, a series of enormously successful bets catapulted the already enormously successful Miami-based firm to the top of the list of largest hedge funds in the world by assets.

Precisely what those bets consisted of is not public knowledge. Reportedly, even Citadel investors have little idea of the trades that have helped the firm’s flagship multi-strategy fund deliver annualised net returns of 19 per cent since 1990.

What we do know is that the assets it deals in – such as the convertible bonds that its founder-owner Ken Griffin traded from his college dorm room – can be out of DIY investors’ reach. And yet there is one market where anyone can peer above the Citadel walls for a near-real-time view of one source of the group’s trades: shorts in UK equities.

Under FCA rules, investors must disclose any short position equal to at least 0.5 per cent of a company’s market value. The regulator then makes these details public. Citadel, which currently has 21 short positions across 18 companies, is one of the City’s most prolific short traders. It has generated dozens of short ideas over the years, many of which are mirrored across its funds.

Some very rough data-crunching reveals a few points of interest. At the point of disclosure, the average position is £17.2mn. By the time a position is closed out – defined as the point at which it dips back below 0.5 per cent value, which takes 425 days on average - Citadel is up between 4.1 and 4.8 per cent, depending on how those trades are weighted. Although they are fewer in number, trades that last between one and three years tend to perform a lot better and compensate for the fact that the majority of trades appear to go against Citadel.

However, the data omits more than it tells. Some of these short positions might be paired with other long or short trades or used in arbitrage, complicating an assessment of them as standalone ideas.

Trying to track the trades’ success is particularly difficult. The disclosure of a short position does not mean it is a new idea (or that it is closed out if the short position dips back below the disclosure threshold), and any price movement fails to account for borrowing or margin costs.

All of which is to say that shorting is very hard to get right, even for the world’s smartest hedge fund. Profitably copying its trades, while working with limited information, is probably even harder.