Why Pension Funds are Dying to Put More Money with Citadel or Millennium-like funds – And what it means for your money!

2021 has been an interesting year for sure – and it is one year where a lot of big names in financial industry that have largely managed to stay under the radar in the general public have come to be known very well. One of the hedge fund / finance household names that became notorious during the GameStop ($GME) and Robinhood debacle is Citadel

The part of Citadel that became well known during the GameStop debacle and political storm was Citadel Securities – an trading firm that actually specializes in market-making. Market making means that they match seller and buyer and their profit on each trade is the spread between what Buyer is willing to pay (bid) and what Seller is willing to accept (offer) – this is also known as Bid-Ask-Spread. Profit in each trade is laser-thin – thanks to increased competition among these technologically savvy firms. What they have lost on each trade, they make up with volume.

Not defending them here, but the rise of many of these firms have been instrumental to narrowing the gap between bid and ask and this has generally helped investors to buy new stock at lower price or sell existing position for higher price. Anyways, this part of Citadel was involved with GameStop issue.

The part of Citadel that I wanted to discuss here is Citadel – the hedge fund. A multi-manager / multi-strategy fund that manages ~$30bn of equity capital. This equity capital is highly leveraged to generate excess return – and because of leverage, Citadel seeks to create a diversified portfolio that really maximizes for the highest Sharpe Ratio and really hates to take market risk – essentially hedging out all the various factors of the stock, including size factors (large cap / mid cap / small cap), industry, etc.) – this strategy is call beta-neutral and this really squeezes out the Alpha.

Under this portfolio construction, you are not going to have +30-40% return, but you can generate 5-10% of return on ASSET basis, but the leverage allows you to generate 15-20% return on annualized basis WITHOUT TAKING MARKET RISK (READ: LOWER VOLATILITY PORTFOLIO) – AND THIS IS WHY PENSION FUNDS ARE DYING TO PUT THEIR CAPITAL WITH CITADEL OR ITS LARGEST RIVAL MILLENNIUM.

SO WHY ARE THEY SO EAGER TO PUT THEIR MONEY WITH THESE BETA-NEUTRAL HEDGE FUNDS?

S&P / NASDAQ are ALL TIME HIGH – truly amazing in that INDEX of the largest economy in the WORLD is up over 2X since mid-2020s.

Pension funds are looking after precious retirement funds AND they also need annual cash drawdown – you need to pay out pensioners annually – therefore, they must focus on:

1. capital preservation – retirement funds are highly precious and the ratio of beneficiaries vs. contributors is only getting worse.
2. liquidity – need to pay out retirees every year.
3. preparation for a market correction – market correction can wipe out many years of performance.

And Citadel / Millennium fit this criteria because they create portfolio that essentially check all the boxes for them. By hedging out market risk and creating a diversified portfolio, capital preservation is achieved especially in the even of a major market correction and given those funds primarily or solely focus on public market investment products (equities / public credit, but NOT private equity), there is ready market for the fund managers to sell the positions with low trading cost in case of redemption.

Pension funds are also putting A LOT OF MONEY into PRIVATE EQUITY – which is essentially JUST LEVERED EQUITY

Essentially, what they are doing is taking a barbell approach with equities allocation. They are increasing exposure to 1) LARGE UPSIDE ON EQUITES MARKET – through increasing private equity exposure and 2) LOWER RISK/RETURN WITH MARKET HEDGE – and removing allocations that fall in between. This is probably why we are seeing death of long-biased public hedge funds, because they fall in the middle.

SO.. WHAT DOES THIS MEAN FOR OUR PERSONAL ACCOUNT TRADING?

Pension funds are smart people with a lot of resources at their disposal to create their view and I think it is a good idea to see what they do and apply their view.

Obviously, as private investors, we can’t allocate our capital with those beta-neutral market strategies – even large pension funds are being denied for more allocation due to capacity issues – there is so much capital you can manage (although some funds do over-reach).

I can’t tell you what to do, but these are somethings that I have done with mine to reflect learnings from pension funds.

I AM ALSO TAKING BARBELL APPROACH – I MAINTAIN LONG POSITION IN THE EQUITIES MARKET (OVER LONG TIME HORIZON MARKET GOES UP) BUT I AM TAKING BARBELL APPROACH IN MY PERSONAL ACCOUNT: 1) ULTRA HIGH GROWTH COMPANIES OR HIGH LEVERAGE COMPANIES AND 2) HIGH VALUE NAMES (DIVIDEND STOCKS), BUT NOTHING IN BETWEEN.

Doubling down on my highest conviction growth names like Tesla ($TSLA), Redfin ($RDFN), Palantir ($PLTR), or Twilio ($TWLO).

AND I have value or high current income stocks, like mining companies – such as BHP ($BHP).

What do you think about this portfolio construction? Please share your thoughts!

*not financial advice.