Inside Blackstone’s hedge fund investing platform

Voiceover: This podcast is intended for institutional and professional investors, not retail use, it is for information purposes only.

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Kumar Panja: Welcome to the J.P. Morgan Making Sense channel, I'm Kumar Panja and I'm excited to be joined by two very knowledgeable leaders from Blackstone. With me today is Joe Dowling, who is a Senior Managing Director and Global Head of Blackstone's multi-asset investing business called BXMA, and Riad Abrams, who is a Senior Managing Director in BXMA as well, where he serves as Head of Strategy, Risk and Quant Analytics.

Joe Dowling: Kumar, thanks for having us today.

Riad Abrahams: Thanks for having us.

Kumar Panja: Thank you for being here. I'm glad we can make this work. What a week to be in London. Are you enjoying the heat wave?

Joe Dowling: Absolutely.

Riad Abrahams: I have a new appreciation for air condition.

[Laughter]

Kumar Panja: Let's get into this. So for the next few minutes, I'm going to be asking Joe and Riad about Blackstone as an investor in hedge funds, how that fits into their wider business, their philosophy and approach to managers, as well as building a portfolio that works for their institutional investor base.

To start, can you give us an overview of what Blackstone multi-asset investing is and where it fits into the broader Blackstone platform?

Joe Dowling: So Blackstone has about 1.3 trillion of assets and BXMA, the multi-asset division, represents about 105 billion of those assets, 300 people spread across 12 global offices. And Kumar, the way that I think about the division is I divide it into four different pieces. The first piece is absolute return, which is about 67 billion of assets. And it's headed by my partner, David Ben-Ur, and it delivers uncorrelated consistent returns designed to be all weather by investing in third-party funds. In a world where stocks and bonds are correlated 70% of the time since 2022, it is really increasingly become a core part of institutional portfolios.

The second group is our multi-strategy group, 14 billion, and it's really our direct investment platform, and it marries a fully unconstrained investment mandate with the power and insight of the BX platform to deliver uncorrelated strong returns.

The third pillar is what we call total portfolio management. It's 16 billion, where we invest in an endowment style way with a long-term investment horizon across public and private markets. And David Ben-Ur and I are co-CIOs of this business. And then finally, we have Harvest, which is a dedicated liquid energy infrastructure platform that focuses on essential infrastructure and companies that help power our economy. And US power demand, by the way, is expected to grow by 65% in the next 15 years.

Kumar Panja: Great. Thank you. That's super helpful. Joe, you joined five years ago from Brown to lead BXMA or BAM as it was known then. When you joined, what was your vision for the business and how have you seen the platform evolve since then?

Joe Dowling: So the first thing is that my number one priority is what I say to John Gray, performance, performance, performance. And I do that because he's a real estate expert, and in real estate, it's all about location, location, location. But in our business, it's about performance, performance, performance. So we are obsessed with performance at our shop, and we're going to get into that. The second is to develop strategic partnerships with our clients. And we want to be the go-to thought partner for our LPs. My third priority is to deeply integrate into Blackstone to drive competitive advantage. And the power of the BX ecosystem is really our secret sauce. I mean, Riad, would you agree?

Riad Abrahams: Yeah, a hundred percent, Joe. And I think folks don't always appreciate just the breadth of the platform. You know, we own 270 portfolio companies, 13,000 global real estate assets. We've made loans to 5,000 corporates. We run 90 different strategies across the firm. And when you think about that platform, it creates a huge proprietary data set. It creates access, relationships, infrastructure. And ultimately, when you think about our ability to deliver on performance to be that thought partner for clients, the ecosystem is a huge, huge source of competitive advantage.

Joe Dowling: And finally, Kumar, we want to hire, retain, and develop the best talent. We want to promote a culture of A players, and we spend a lot of time on that. Because at the end of the day, our assets are going down the elevator at night, and we want to make sure that they come back.

Kumar Panja: (laughs) That's great, Joe. So performance is obviously a very big thing, as you say. Talk me through how performance has been since you've joined.

Joe Dowling: So we're obsessed on this, and we not only measure it by the absolute return, and we've basically done two times the performance of the prior five-year period. So think last two years have been 12 net in our absolute return business. But more importantly, we have been up 22 consecutive quarters, and we have beaten a 60-40 portfolio by a considerable measure. We've also improved the portfolio resiliency by decreasing underlying manager correlations by 75%.

Now, we're going to get into this, but that is the single most important thing, is to get those cross-correlations down, because that's the difference between having diversification or di-worse-ification, and we want to get into that. And then we also improved the liquidity of the platform by about 30%.

Kumar Panja: I mean, that consistency is something that managers can only aim to kind of replicate.

Joe Dowling: It's interesting. It comes down to portfolio construction and how you think about different types of managers. And I know we're going to go into manager selection, but that is one of the things that is critical. And I think when you bring an investor mindset to portfolio construction, it really differentiates.

Kumar Panja: Yeah. Well, that's a great segue. Thank you, Joe. So let's now talk a little bit about managers. What does it take for a manager to receive an investment from your business?

Joe Dowling: The first thing that I look for is the pedigree. Where has the person been trained and what competitive advantage do they have in their process? And is it repeatable and scalable?

Then I'm looking at alignment. Do they have their own skin in the game? Are they obsessed by the game of investing? Is that their primary focus and what they think about 24-7, 365? And the best investors that I have encountered, it's literally in their DNA. They would do it no matter what, even if they were only managing $25 million. They're just obsessed. They're absolutely obsessed. And then I look for street smarts. So there are a lot of people that are academically smart, but the markets incorporate the emotions of people and the volatility associated with that emotion. And taking advantage of that, you have to be a little bit street smart.

And what's interesting is if you think about it, most people, when they're doing due diligence on managers, the biggest mistake I see is they don't spend enough time with the managers. So maybe you have three or four meetings with a manager, and then you're going to commit hundreds of millions of dollars. We are the opposite of that. We take months and months and months. We want to understand these investors. We want to understand how they interact with companies. We'll often accompany them to see companies. We want to read and understand their research process. And so that, when you start to get that depth, for instance, when you go with a manager to a company, then immediately you know what kind of questions that investor's asking, whether the company knows him or not, his insights into the industry.

So it's just another way. And what I like to say is, when you go on vacation with another family for a week, you know that family at the end of the week. You're eating all your meals with them. And so that's really what we want to do. Not vacation with our managers, but actually go and-

Kumar Panja: The good, bad, and the ugly!

Joe Dowling: And spend time with them and figure out what makes them tick. And it's the little things. How are they treating the waiters when you're at a restaurant? What is their work ethic? Are they working out before the day starts? Are they calling their family? All these little things make a difference. We try to go deep. That's part of the secret sauce.

Kumar Panja: That's really good.

Joe Dowling: Anything to add, Riadh?

Riad Abrahams: Yeah. I would just say that, echoing Joe's comments, the analysis of the manager's returns and how they make money and the rigor of our quantitative approach is very key. So we really want to make sure that.

Joe Dowling: The money ball.

Riad Abrahams: Yeah. We want to understand, is it an idiosyncratic source of return? Is it repeatable? Is it sustainable? What is the good and bad weather for the strategy? What is their risk management process? How do they make decisions when things go against them? But I would strongly echo Joe's point on focusing not just on the quantitative analysis, but also the qualitative understanding of what makes them tick. Because ultimately everyone is going to go through a difficult period. And during those difficult periods, how they respond, how process-driven they might be in terms of the decisions they make in that moment of stress, that's really critical to sustaining returns over time.

Kumar Panja: So you've just described what, how you would look at managers and what your expectations are from them. And it's a kind of a 360 degree assessment of what they're like. What can they expect back in return from a Blackstone relationship?

Joe Dowling: So what I'm most proud of is the duration of our capital and our ability to invest at moments of extreme volatility. And we do this all the time. We call it rebalancing, but there isn't a year that goes by when we don't have a manager that's having a drawdown or a problem. And I think what we're really known in the industry for is stepping in and supporting people. And really what typically happens in these pullbacks is that a lot of investors will bother the manager and try to figure out if it's broken or not. But when you do the type of research and get the kind of conviction that we get, you're able to make a decision based on the market dislocation versus a manager misfunction. And it's super important because it's really, really hard to step in. The second thing is we have a lot of operational expertise and a lot of operational infrastructure. So we have a track record of helping our investors fine tune some of the things in their back office, some of the things with the prime brokers. And then, you know, we like to grow with our managers.

Kumar Panja: Right. Let's talk about performance. And it's clear to us that the hedge fund Alpha Winter is behind us. Volatility has returned in the markets and performance is improving. How is the current environment impacting your portfolio in the way you think about managers and general activity levels?

Joe Dowling: Well, I think the first thing is if you look at the correlation between stocks and bonds over the last 50 years, they've actually been correlated about 64 percent of the time. And since 2022, that number has gone up into the 70s. And what does that mean? What that means is that the traditional 60, 40 or 70, 30 portfolio is not working 64 percent of the time with both asset classes moving up or moving down at the same time. And so what we have found is a lot of our clients are looking for a solution for that. And that's exactly what we're providing. We're providing both in our multi-asset hedge fund and in our absolute return strategies, uncorrelated return streams that are very consistent and double digit. And that is resonating. And we can give that experience to our clients.

Riad Abrahams: I think this is the single most important change in markets that portfolios face. If you look at that period between the great financial crisis and COVID, the QE era, it was in some ways the perfect environment for the 60, 40 portfolio. And it made portfolio construction look easy. And since the end of COVID, you know, to Joe's point, bonds have been down 80 percent of the time that equities are down. So portfolios are crying out for a solution because ultimately, if you want to compound capital over time, you have to be able to stay invested in your equity exposures. Bonds used to allow you to do that. They no longer work.

Kumar Panja: Right. So given the elevated stock bond correlations, hedge funds have clearly become increasingly valuable as a tool for institutional investors. And we're seeing that as well in terms of the volumes that we get in terms of our brokerage business and financing. But at the same time, there is, well, there are rising correlations between managers. How do you manage that kind of dispersion and directionality in your overall book?

Joe Dowling: Kumar, that is the single most important thing when you're constructing a portfolio. And we think about stacking uncorrelated returns on top of each other. And we really focus on the pairwise correlation across our manager sets. And we like them to be very low because that's really the difference between diversification, true diversification, or di-worsification, where you're basically adding the same manager and the same underlying factor exposure. So in addition, you have to size the manager positions accordingly to embrace the amount of volatility that each manager has. And I think where a lot of people, when they're designing portfolios, they optimize for sharp. And when you optimize for sharp, it's great. You can have no left tail, but you lose your right tail. So the secret is really focusing on stacking uncorrelated managers and not constraining the volatility of the underlying manager. We're very happy if we have managers that are up or down 15 or 20%. That doesn't bother us. We actually, we love that. And I always say to people in my shop and Riad, if all of our managers are making money, you have a big problem. You just don't know about it, which is they're all correlated to the same thing. And when the tide goes out, it's going to be a problem.

Riad Abrahams: Yeah. I was actually going to follow up with that point. Defining correlation is actually kind of tricky because if you think about the quant space or the multi-strat space, generally they're up 80% of the months. And so if you look at the correlation between those types of managers, it's going to be high.

Kumar Panja: Yeah. There's a fair amount of correlation.

Riad Abrahams: And honestly, when things are working well, you want things to be correlated. But what we also spend a lot of time focusing on is the correlation and drawdown. And especially in more trading oriented managers, do they all suffer the same negative impact during that moment of dislocation? And we'll also look at that correlation structure across multiple different look back windows. So we spend a lot of time trying to dive into the structural lack of correlation, especially in the down markets.

Kumar Panja: Got it. The drawdown analysis is key. That's where you don't want there to be correlation. On the upside, correlation can work in your favor. So we touched on early stage managers. How do you work with early stage or niche strategy managers?

Joe Dowling: So we've been seeding managers, staking them, backing them since 2007. And obviously, when you look at the research, what it shows is that emerging managers outperform established managers. And if you just look at the data between March 2020 and Feb 25, emerging managers delivered a five-year annual return of 16.2% versus 8.5% from their larger, more established peers. That's almost two times the return. That data is from Prequin.

Kumar Panja: And you've been over decades for one of the main investors and supports for early investing, but your approach has evolved recently. Talk us through that.

Joe Dowling: Well, I think the landscape has changed. So if you think about the multistrats of the world, they're actually doing quite a lot of outside investing in other funds. It's become a core part of their business. And with their pass-through, they become very indifferent to paying full fees. So the landscape has really changed, and they are the lowest cost of capital.

Now, in many launches, we join them, and one must ask themselves, well, why are these successful managers peeling out of these multistrats? And I think the main reason is that they don't want to just have one source of capital. They want to diversify their source of capital and start to run their businesses. And this is happening more and more. There isn't a year that goes by that we're not combining with one of the multistrats to put someone in business. But that changes the landscape. And for us, seeding now requires a bigger check, and it also might not include a rev share. And what I always think about in rev shares, and Riad, feel free to jump in here, is you want to be very careful that you don't get adverse selection. And there are some situations in which a rev share makes sense, but there's a lot of times when a rev share makes no sense. Or if you're seeding a smaller niche, high alpha pond manager, you don't want them growing their assets. You actually want them to have really high contained returns.

Riad Abrahams: Yeah. And I would, on the point of adverse selection, clearly the use of SMAs, you see it in all the prime data. It comes up in terms of how prevalent it has become, particularly as now the multistrats are also allocating externally. This problem of adverse selection, I think, is pretty acute. The beauty of the SMA structure, though, is that you have the full transparency. And so you can really dive deeply into understanding how the manager is making their money and how sustainable it is. I think one of the reasons why we are, in many cases, a preferred partner is the external allocation from a traditional multistrat can come with a lot of strings attached to it.

Joe Dowling: Especially the liquidity provisions.

Riad Abrahams: The liquidity provisions. And I think when we decide to partner with a manager, it's after a significant amount of diligence and understanding. And obviously the objective and the goal is to be with that manager for a long period of time. So I think there is a different nature to our relationship with a manager where we are accessing them through an SMA versus what a traditional platform might do.

Kumar Panja: Okay. Let's turn to investors now. We at JPMorgan have been receiving overwhelmingly positive feedback and sentiment on hedge funds, of all strategies, really, from sovereign wealth funds to other institutional investors to family offices. So more money is queuing up to come into this space. What are you hearing from your investors and how is that shaping the way your portfolio is evolving?

Joe Dowling: The demand for hedge funds has really been picking up and I think it's pretty logical in the world that we live in of deglobalization, no central bank coordination, geopolitical conflict. And what that leads to is that leads to volatility. It leads to dispersion. And these strategies that we're talking about that Riadh and I are really focused on, absolute return and multi-strat investing, really provides... That's really the jet fuel, the volatility and the dispersion for those strategies. And so they've been doing really well. They've been very consistent double-digit returners for a number of years, completely uncorrelated to stocks and bonds. So yes, Kumar people are starting to wake up. And if you look at the allocations for some of the very sophisticated endowments, their allocation is 20% to absolute return. If you look across the Ivy League, it's basically 20%. Now, they're using it as a fixed income replacement vehicle. But I would say that the inquiries from people who are trying to solve this stock bond correlation problem and take advantage of a very volatile world, the asset class is getting hot, pun intended here in London.

Kumar Panja: Do you think some of that cooling, should we use your phraseology, on hedge funds stemmed from, going back to a point that you made earlier Riad, hedge funds were not performing because the environment wasn't right for them. And that's when we saw at JPMorgan, a lot of money moving to the private space, particularly sort of post GFC. It's changed now, because as you say, Joe, the conditions are right. But do you feel that was also kind of explained?

Riad Abrahams: I think broadly, they were still performing, but I think the alpha backdrop wasn't as strong as it is today. Because what's interesting to me when you look at the data is the exact same catalyst behind this switch in the stock bond correlation is likely the same catalyst behind higher volatility and higher dispersion, which is as Joe described, that's the high octane fuel for all kinds of different hedge fund strategies. So you have this perfect confluence of events that at the exact moment portfolios need a solution, hedge funds as that solution are enjoying tailwinds. And so when you look at the prime data that comes out from the likes of JPMorgan and others, I think for the second year in a row, hedge funds are the most sought after asset class. And I think the most sophisticated institutions are there already.

But if you go down and look across the spectrum of investors, what's interesting is if you look at the wealth community, they are now starting to be very interested in hedge funds. And there's a remarkable gap between where they're allocated today and what a lot of the CIOs of the wealth platforms advocate. And so if you look at it, most CIOs would say you should have a 10% allocation as a high net worth investor or family to absolute return or to hedge funds. And currently that only sits at 1%. So I do think there's going to be a dramatic demand for high performing multi-strategy hedge funds in particular.

Kumar Panja: Which should be good for your business and good for all of us. But one of the things we also note is that some investors are increasingly building their own all-weather portfolios using separately managed account technology. And on the one hand, this provides managers with optionality. On the other hand, it contributes to market fragmentation and creates more competition for low-capacity managers. What impact have you seen from the growth of these portfolios?

Joe Dowling: Well, there's certainly going to be institutional attempts to try to do SMA platforms and many will succeed and many will fail. I think most people will underestimate the difficulty of actually doing it from just an operational setup, a risk management reporting and infrastructure problems associated with it. So no doubt it's a trend. Riad?

Riad Abrahams: Yeah. I think it sounds great on the surface. It's quite complex to execute well. When you think about the relationships with the primes, the systems you need to monitor the leverage, processes in place to handle the adjustment of the margin rates. And part of the beauty of SMAs as an investor is that you have the full position transparency, but you also have to the analytical power to actually make use of it. Because if you make use of it well, it means your portfolio construction is really, really robust. And that's what we've seen with our managed account platform inside BXMA. But we speak to a lot of institutions who have gone down this path and then they'll come to us and say, we're not getting the same results as you guys. And it's because it's not as simple as clicking a button and onboarding onto some SMA platform. There's a lot of steps that go into it.

Kumar Panja: And it goes to your earlier point on the power of the platform, the scale, the investment in risk management through technology, your access to prime brokers like us and then access to allocations, balance sheet. These are things that take years to fine tune and continue to kind of invest in and build.

Joe Dowling: There's no doubt that running an SMA is a very powerful tool though, but it does require a lot of focus on the portfolio construction, the sizing, the rebalancing, making sure that the managers stay within the guidelines that you've given them for liquidity. What's interesting though, once you have this platform, you can really start to do some unique things and on our SMA platform, what we've been able to do with the top 20% of our managers is really extract even more alpha through co-investments. And it's a program that we've been doing ad hoc for about four or five years, but now we've systematized it.

Kumar Panja: Okay. Let's turn to something which investors often raise with us, and that is a concern about increased leverage in the system. It's within a reasonable range relative to the current market size. I mean, that could change obviously, but how do you address these concerns with your investors? Do they raise it with you?

Joe Dowling: Well, we monitor this pretty carefully because what we've seen is a trend towards what we call the gamification of the markets, and it's real. And if you just look at things like levered ETFs, they average 43 billion in volume per day, and that's 8X what it was in 2019. Zero day options, options that expire in one day are now 60% of the S&P daily options volume. It was less than 5% in 2019. So this tells me that people are speculating heavily in the short term. These are not long-term investors that are doing this.

Kumar Panja: But it provides useful volatility for our hedge fund managers, right?

Riad Abrahams: 100%. Obviously, there's the old quote of the market is a voting machine in the short run, but a weighing machine in the long run. And I think the gamification does make that even more true today. But the other thing with the leverage that we pay attention to is where it intersects with crowded positioning, because that's where it's really toxic. Because then if that crowded trade or theme does reverse, then the leverage amplifies the move on the downside. And it goes back to that original point around correlation and drawdown correlation. It is something we're very attuned to, and in every way we can, we try to monitor it in markets and across our managers.

Joe Dowling: If you think about it, Kumar, the margin debt, as measured by all the FINRA member firms, is 1.3 trillion this year. And that's the highest level on record. So if you think about I guess spring, this market is fully loaded, fully invested, and ready for some volatility.

Kumar Panja: Which is going to be good.

Joe Dowling: It's good for us.

Riad Abrahams: Yes, great for us.

Kumar Panja: So looking forward then, what observations would you share for managers to kind of make their businesses more resilient and better adapted to the environment going forward?

Riad Abrahams: You know, I think that the more that managers can develop a process that allows investors and allocators to believe in the sustainability of their returns across the cycle, I think that's the number one thing. And I think what's going to most allow you to do that on a go forward basis, it's how you use data in your process, and how you're able to now capitalize on all of these new AI tools to really accelerate your research process and develop and further enhance your investment strategy.

Joe Dowling: I would say a focus on AI. And really, like Riadh said, I can't emphasize enough, being on the forefront of using AI agents and other tools to help with your research, with your monitoring of your portfolio companies, with your due diligence process. I think it's a game changer. And unfortunately, most people aren't embracing it. There are a few managers that are way, way ahead. Now, the quants have been doing this with machine learning for the last decade, but we're really seeing people catch up. And what I'm interested to see, and the jury is still out, on whether it's going to be the big firms that benefit from AI, or if it's going to make the emerging manager that much more powerful with all of these AI agents out there as analysts and sources of, call it alpha gathering.

Kumar Panja: So-called democratization.

Joe Dowling: Exactly. Do you have an opinion on that, Riadh? Where's it shaking out?

Riad Abrahams: I do. So I think on the one hand, the tools definitely will democratize a lot of the analysis, and certain aspects of the investment process will become commoditized. But ultimately, what's going to be the source of competitive advantage is whether or not you have proprietary data, and whether you can access all of the external data. 

 I do think that if the larger firms do this well, they will have a proprietary data advantage that is their own, and they will be able to integrate that with all the external data sets that are now available and have AI sit on top of it. But it does require strategy and forethought. But it is, just to come back to one of our original points on the power of Blackstone and BXMA, we have probably the largest proprietary data set in the world as a result of our platform, and ultimately that's going to be a huge source of competitive advantage going forward.

Kumar Panja: Going to be an interesting time going forward, isn't it?

Joe Dowling: It's our number one focus right now.

Kumar Panja: Great. Well, I think we're at time. That was excellent. We could have gone on for a lot longer. Thank you so much, Joe and Riad, for your insights.

Joe Dowling: Thanks, Kumar, for having us.

Riad Abrahams: Thank you.

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