I was looking at the performance charts from the second week of March, and for a few days there, it looked like the entire multi-strategy hedge fund world was staring into an abyss. We saw a four plus standard deviation drawdown in the momentum factor between March seventh and March tenth, which is essentially the financial equivalent of a thousand-year flood happening twice in a single weekend. If you were holding the winners of the last six months—mostly the big AI and energy names—you weren't just losing money; you were watching the floor fall out from under the entire strategy.
It was a massive, systemic deleveraging event. We saw some of the biggest names in the industry—firms that usually pride themselves on being market-neutral—forced to trim their most crowded positions just to keep their internal risk parameters in check. When a four-standard deviation event hits, the math that governs these funds basically tells them to stop everything and sell. Today's prompt from Daniel is about the structural divide between hedge funds and mutual funds, and honestly, that recent volatility is the perfect lens to view why these two things exist in such different regulatory and strategic universes.
It is interesting because on the surface, they both look like the same thing to a casual observer. You give your money to a group of professional investors, they pool it with everyone else's money, and they try to make it grow. But as of March twenty twenty-six, the scale of these two worlds is vastly different. We are looking at a five trillion dollar hedge fund industry globally, which sounds massive until you look at the mutual fund side. In the United States alone, mutual fund assets have reached thirty-one point eight trillion dollars. Why is there such a massive gap in scale if they are both just investment pools?
The gap is primarily a function of who is allowed in the room and the regulatory "moat" built around the average consumer. Mutual funds are the democratic version of investing. They are open to the general public, often with minimums as low as five hundred or a thousand dollars. Because they are open to everyone—including people who might be putting their last five thousand dollars into the market—the Securities and Exchange Commission subjects them to the Investment Company Act of nineteen forty. That is a very restrictive, very protective set of rules designed to ensure that "grandma's retirement savings" aren't being bet on a high-leverage crypto-arbitrage play. Hedge funds, by contrast, operate under specific exemptions from that nineteen forty Act. Those exemptions allow them to do almost anything they want, but the trade-off is that they are strictly limited to accredited investors and qualified purchasers.
Right, so we are talking about the "wealthy only" sign on the door. To be an accredited investor, you generally need a net worth over one million dollars excluding your primary home, or an annual income over two hundred thousand dollars for at least two years. And if you want to get into the really elite, multi-strategy funds, you often need to be a qualified purchaser, which requires at least five million dollars in investable assets. Is that barrier there because the strategies are actually dangerous, or is it just about preserving an exclusive club for the ultra-wealthy?
It is less about exclusivity for its own sake and more about the complexity of the risk. Because hedge funds are restricted to what the law calls "sophisticated investors," the regulators assume these people can handle a total loss. This allows hedge funds to use tools that are strictly limited or outright banned in the mutual fund world. I am talking about high levels of leverage—borrowing money to amplify bets—concentrated positions where one stock might make up twenty percent of the portfolio, and the ability to go short. A typical mutual fund is "long-only," meaning they buy stocks and hope they go up. If the market drops twenty percent, a long-only mutual fund manager is considered a hero if their fund only drops fifteen percent.
That seems like a pretty low bar for a hero, Herman. "I lost you less money than the other guy."
In the mutual fund world, it is all about relative performance against a benchmark like the Standard and Poor's five hundred. If the index is down, and you are down less, you won. Hedge funds, on the other hand, usually aim for absolute returns. They want to make money whether the market is ripping higher or crashing. To do that, they use hedging techniques, hence the name. They might buy one tech stock they love but short another one in the same sector to cancel out the general market risk. They are betting on the "spread" between the two companies, not the direction of the whole market. That process requires a level of complexity and margin debt that the Securities and Exchange Commission simply does not want retail investors touching without a significant financial cushion.
Let's talk about the liquidity mismatch because that feels like where the rubber really meets the road during a crisis like the "Multistrat-mageddon" we saw a few weeks ago. With a mutual fund like the Vanguard Total Stock Market Index—which, by the way, just crossed two trillion dollars in assets this year—I can sell my shares today and have my cash tomorrow. It is daily liquidity. But if I am in a fund like Citadel or Bridgewater, I might be looking at a lock-up period of one to three years. Why would anyone agree to have their money held hostage for three years?
Because that liquidity difference is the secret sauce for the hedge fund's strategy. If a mutual fund manager sees a massive outflow because retail investors are panicking about a war or a bank failure, they are forced to sell their holdings immediately to meet those redemptions. They have to sell what they can, which is usually their best, most liquid stocks, not necessarily what they want to sell. Hedge funds use lock-up periods and "gates" to prevent that. It allows them to invest in illiquid assets, like private credit, distressed debt, or even physical commodities, that might take months or years to pay off. They do not have to worry about a sudden exit of capital forcing them to liquidate a position at a fire-sale price. They can afford to be the "patient money" when everyone else is panicking.
But we just saw that "Multistrat-mageddon" event where they were forced to de-risk anyway. If they have these lock-up periods to protect them from investor panics, why did they have to sell off their momentum positions so aggressively between March seventh and tenth?
That comes down to internal leverage and the "pod" model that firms like Citadel have popularized. Ken Griffin's model involves hundreds of independent teams, or pods, each managing a slice of the capital with very tight, very unforgiving risk limits. When that momentum factor draw-down hit four standard deviations, those pods hit their "stop-loss" triggers. Even if the investors cannot pull their money out, the internal risk management systems force the traders to sell to protect the firm's capital. It is a mechanical de-risking. It actually makes the firm safer in the long run because it prevents a single pod from blowing up the whole fund, but it creates that massive short-term volatility in the broader market because these pods are all often crowded into the same high-performing stocks. When the machines say "sell," they all sell at once.
It sounds like the pod model is basically a way to industrialize alpha. Instead of one genius like Ray Dalio making big macro calls at Bridgewater, you have five hundred specialized nerds each trying to find a tiny edge in a very specific corner of the market.
The shift toward the pod model is the most significant trend in the industry over the last decade. It has moved hedge funds away from being "star manager" vehicles and toward being institutional platforms. This connects back to the fee structure too. Everyone knows the classic "two and twenty" model, where the fund takes a two percent management fee and twenty percent of the profits. In the mutual fund world, that would be scandalous. The average mutual fund expense ratio is now between zero point five and one percent, and they do not take a cut of your profits.
I have noticed the "two and twenty" thing is starting to crack, though. I was reading that the twenty twenty-six trend is moving more toward "one point five and fifteen" or even tiered structures where the performance fee only kicks in after a certain hurdle rate is met. Is that because they are finally feeling the competition from cheaper products?
Partially, yes. The fees are under pressure because of the rise of "Liquid Alts" and the general "retailization" of these strategies. We are seeing a blurring of the lines. There are now mutual funds and "Interval Funds" that try to mimic hedge fund strategies—using things like total return swaps to get exposure to private markets—while still fitting inside a regulated mutual fund wrapper. They offer more frequent liquidity than a traditional hedge fund but charge higher fees than a standard index fund.
Does that actually work? Or is it just a watered-down version of the real thing that gives retail investors the illusion of sophistication while charging them three times the price of a Vanguard fund?
It is often a middle ground. You get some of the diversification benefits, but you are still limited by those "forty act" rules. You cannot use the same level of leverage that a pure hedge fund uses. For example, a hedge fund might be "three hundred percent long and two hundred percent short," meaning they are using massive amounts of borrowed money to amplify their bets while remaining market-neutral. A mutual fund simply cannot do that. The "Names Rule," which has a compliance deadline of June eleventh, twenty twenty-six, is actually going to make this even tighter.
Explain the Names Rule, because that seems like it is going to cause a massive headache for a lot of these hybrid funds.
The Securities and Exchange Commission is requiring that if a fund's name suggests a focus on a particular type of investment—like an "ESG Fund," a "Growth Fund," or an "Alternative Fund"—at least eighty percent of its assets must actually be in that category. This is designed to stop "greenwashing" and "style drift." For those "Liquid Alt" mutual funds, they have to be very careful that their underlying holdings match what they are telling retail investors. They can no longer just put "Alternative" in the name and then hold sixty percent standard blue-chip stocks to keep the volatility low. It is about transparency for the retail guy.
Speaking of style drift, let's talk about the Iran conflict volatility from March eighteenth. We saw oil prices spike above one hundred ten dollars a barrel. This seems like exactly the kind of environment where the old-school discretionary macro hedge funds shine, while mutual funds just have to sit there and take the hit from rising energy costs.
The divergence there was stark. Discretionary macro funds and energy-focused shops like Old West Investment Management were positioned for this. Old West reportedly saw a thirty-one percent return in just the first few weeks of March because they had heavy exposure to energy and uranium. A mutual fund manager who thinks a war is coming might want to move fifty percent of the portfolio into oil futures, but they likely can't because of diversification requirements that limit how much they can put into a single sector or a single commodity. They are legally required to stay diversified, which protects them from a total wipeout but prevents them from catching these massive, concentrated windfalls.
So the hedge fund is a sniper rifle and the mutual fund is a shotgun.
If you want to use an analogy, sure. But the technical reality is that the hedge fund has the mandate to be concentrated. If they are right, they make thirty percent in a month. If they are wrong, they can go to zero. Mutual funds are structurally prohibited from going to zero in that way because they are forced to be diversified across dozens or hundreds of holdings.
What about the AI side of this? I saw a report saying that over seventy percent of hedge funds are now using machine learning in their core investment process. We have firms like Numerai, which is basically a crowdsourced AI model, and then you have the giants like Coatue Management, led by Philippe Laffont, which is pouring billions into AI infrastructure. Is the "human genius" hedge fund manager becoming an endangered species?
The role of the human is shifting from "stock picker" to "system architect." Numerai is a fascinating example. Richard Craib's whole model is based on giving encrypted data to thousands of anonymous data scientists and having them build models to predict market movements. The scientists do not even know what the data represents—it could be stock prices, it could be weather patterns—they are just looking for mathematical signals. The fund then aggregates those models into a "meta-model." That is a world away from the traditional mutual fund model where a group of analysts in suits visits a factory and talks to the Chief Executive Officer.
It feels like the mutual fund industry is still stuck in the twentieth century while hedge funds are living in twenty forty. But then I look at the assets under management again. Thirty-one trillion dollars in mutual funds. That is a lot of "old school" money that doesn't seem to care about crowdsourced AI models.
That is because the vast majority of that thirty-one trillion is not looking for "alpha," or market-beating returns. It is looking for "beta," which is just the general return of the market. Most mutual fund investors are in forty-zero-one-k plans. They want low costs, high transparency, and the ability to sleep at night knowing their fund isn't going to blow up because a "pod" hit a stop-loss on a momentum trade. The "retailization" trend we mentioned earlier is the hedge fund industry's attempt to tap into that thirty-one trillion dollar pool, but it is a slow process because of the transparency requirements.
That brings us to the Securities and Exchange Commission's delayed Form PF rules. SEC Chair Paul Atkins just confirmed the delay until October first, twenty twenty-six. These rules are supposed to force hedge funds to disclose more about their margin use and their exposure. Why is the industry fighting this so hard?
Because in the hedge fund world, transparency is the enemy of alpha. If everyone knows exactly what Citadel's leverage is or what their most crowded positions are in real-time, other traders can "front-run" them. They can trade against them. The secrecy of hedge funds is a feature, not a bug. It allows them to build massive positions without moving the market against themselves. The mutual fund world is the opposite; they have to disclose their holdings quarterly. If a famous mutual fund manager buys a stock, everyone knows it a few weeks later. In the hedge fund world, you might not know what they were doing until a year after the fact, if ever.
So if I am a listener trying to make sense of my own portfolio, and I see these "Liquid Alt" or "Hedge Fund Lite" products popping up in my brokerage account, what should I actually be looking at? Because the fees are definitely higher than my index funds.
You have to look at the correlation. The only reason to pay a higher fee for a hedge-fund-like product in a mutual fund wrapper is if it moves differently than the rest of your portfolio. If your "Liquid Alt" fund drops ten percent at the same time the Standard and Poor's five hundred drops ten percent, you are just paying a premium for the same risk you already had. You also need to look at the liquidity terms. Some of these new Interval Funds only let you take out five percent of your money every quarter. If there is a real market panic, you might find yourself stuck in a "retail" product that has "institutional" lock-ups.
It is the worst of both worlds. High fees and no liquidity when you need it most.
It can be, if you don't read the prospectus. But for some, it provides access to private credit markets that are currently yielding ten or twelve percent while the public bond markets are much lower. As we saw with the Iran conflict, being able to access those specialized energy or commodity plays can be a massive diversifier. You just have to know that you are trading away your right to exit the position tomorrow morning.
I want to go back to the "Multistrat-mageddon" for a second. We saw the momentum factor collapse. That usually happens when the "smart money" all realizes they are on the same side of a trade and they all try to get out of the door at the same time. Does the rise of AI and machine learning make these "crowded trade" collapses more likely?
There is a strong argument that it does. If seventy percent of the five trillion dollar hedge fund industry is using similar machine learning models, those models are likely to identify the same patterns. They all buy the same "momentum" stocks because the data says those stocks have the highest probability of going up. Then, when the data changes slightly—maybe a shift in interest rate expectations or a geopolitical event—the models all signal "sell" at the exact same microsecond. We are moving from a world of "human panics" to "algorithmic flash crashes." The "Multistrat-mageddon" in early March was a perfect example of a factor-driven squeeze where the machines were essentially fighting each other for the exit.
And the mutual fund investors were just sitting there, probably not even realizing it was happening until they checked their balance at the end of the month and saw a dip.
The mutual fund is the tortoise. It is slow, it is steady, and it is highly regulated. The hedge fund is the cheetah. It is incredibly fast, it is highly specialized, but it can also overheat and need a long period of rest—or a lock-up—to recover.
We have covered a lot of ground here, from the five trillion dollar scale of hedge funds to the thirty-one trillion dollar behemoth of mutual funds. We have seen how the pod model at firms like Citadel creates a different kind of risk than the "star manager" model at places like Bridgewater. And we have seen how recent events like the Iran conflict and the March momentum crash highlight the strategic differences.
The big takeaway for me is that the line between these two is going to keep blurring. By the time we hit the compliance dates for the Names Rule in June and the Form PF rules in October, the industry is going to look very different. We are seeing a "barbell" effect. On one side, you have ultra-cheap, massive index mutual funds that just track the market. On the other side, you have highly complex, AI-driven, multi-strategy hedge funds that are trying to beat the market. Everything in the middle—the active mutual fund manager who charges one percent to try and pick stocks—is getting squeezed out of existence.
So, what is the future of alpha? If everyone has the same AI, and everyone is using the same pod model, does the edge eventually just disappear?
Alpha is a moving target. As soon as a strategy becomes "standard," it becomes "beta." The next frontier is likely going to be in "unstructured" data—things like satellite imagery of oil tankers, or real-time sentiment analysis of private communications, or even biological data. The funds that can find the data that the AI hasn't chewed on yet will be the ones that justify those performance fees.
It sounds like a never-ending arms race where the cost of entry just keeps going up.
It is. That is why we see the assets under management concentrating in firms like Citadel and Millennium. You need billions of dollars in technology spend just to stay competitive. The days of two guys in a garage starting a hedge fund are largely over. You need a server farm and a team of data scientists.
Or a crowdsourced model like Numerai.
Even Numerai is a massive technological undertaking. It is just a different way of organizing the labor. Whether it is centralized like Citadel or decentralized like Numerai, the common thread is that data and compute are the new capital.
This has been a deep dive into the guts of the financial system. We have covered the structural, regulatory, and strategic divergence that defines how the world's wealth is managed. If you want to dig deeper into the types of people who actually invest in these hedge funds, we did a full exploration of that in episode fifteen zero two, which was all about the five point five trillion dollar rise of the modern family office. It really puts the "accredited investor" conversation we had today into a different perspective.
And if you are interested in how the energy-focused strategies we mentioned handled the Iran conflict volatility, check out episode fourteen twenty-six, The Invisible Engine. It breaks down the oil derivatives market that these discretionary macro funds use to place their bets.
Thanks as always to our producer, Hilbert Flumingtop, for keeping the gears turning behind the scenes.
And a big thanks to Modal for providing the GPU credits that power the research and generation of this show.
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