In Tough Times for Hedge Funds, These Are the Ones That Stand Out The hedge-fund industry has trailed the market for 10 straight years, but our review shows that many smaller funds are doing well By Eric Uhlfelder https://www.wsj.com/articles/in-tough-times-for-hedge-funds-these-are-the-ones-that-stand-out-11557108360?mod=searchresults&page=1&pos=1 May 5, 2019 10:06 p.m. ET The hedge-fund industry continued its losing streak last year. The industry once again trailed the market in 2018, marking 10 straight years it has underperformed the S&P 500, according to data from BarclayHedge. But the general decline has masked a more complicated truth. My recent review identified hedge funds—private investment partnerships designed for wealthy individuals and institutional investors—that have managed to outpace the market not only last year but over much longer periods. One of the findings was a link between fund size and long-term performance. But not the way many may think. Smaller funds often do better. Some large, venerable managers certainly are still doing well, including Renaissance Technologies’ $27.1 billion equity fund (up 15.34% based on trailing five-year net annualized returns); the $18 billion global macro fund Element Capital (up 13.28%), which targets investments triggered by shifts in key economic indicators; and Citadel’s $19.3 billion Wellington multistrategy fund (up 11.86%). All those returns since the beginning of 2014 are well above the market’s annualized gain of 8.49% over the same period. Still, of the 60 established diversified funds in the review with the best five-year returns, more than half are managing less than $1 billion. MMCAP out of Toronto, for example, has $621 million in assets but has generated returns of nearly 28% a year since the beginning of 2014. The fund’s “event driven” strategy typically seeks out opportunities related to events like mergers and corporate structure, and also engages in private investments. Hong Kong-based KS Asia Absolute Return, a $720 million multistrategy fund, is delivering annualized returns of more than 20%. New York-domiciled MAK One ($458 million), which targets distressed credit and equity opportunities, has been realizing returns of nearly 19.5% over the past five years. The managers of these three funds declined to be interviewed for this article. But a co-manager of another of the smaller funds, Amin Nathoo at the $354 million hedged-equity Anson Investments Master Fund, says, “We’re able to more quickly respond and profit from opportunities across all segments of the market than much larger funds that can’t establish sufficient exposure in smaller-cap shares.” Anson returned more than 19% last year and has racked up net annualized gains of 11.8% since its launch in July 2007, compared with 6.8% for the S&P 500. The 60 funds reviewed were filtered from thousands that report to three databases of hedge funds that met four criteria: broad investment strategies only (i.e., no country, sector or industry funds and/or leveraged versions of core funds), a minimum of $300 million in assets, performance history of at least five years and gains of at least 5% in 2018. The last parameter was applied because 2018 was the first year in a decade that the S&P 500 lost money, and hedge funds faced criticism that they aren’t truly hedges. ‘Structured’ stands tall The review’s top-performing strategy is structured credit. Representing one-quarter of the 60 funds, structured credit involves pools of debt obligations that generate cash flows supporting various slices, or tranches, that vary from investment-grade to non-investment-grade and equity. They each come with distinct risks and yields. Though the strategy dates back well before 2008, the vast majority of extant structured-credit funds came into being after the financial crisis, in large part due to regulations that now prevent banks and insurance companies from holding non-investment-grade and unrated tranches of structured credits. Most managers target mispricing in these tranches. Hudson Cove Credit Opportunity Chief Investment Officer David Wu argues the strategy’s rally since the end of the financial crisis will likely continue for a while. Unlike what happened to mortgage securities a decade ago, Mr. Wu sees much better underwriting, less-leveraged consumers and corporations, and lower default rates. But he believes managers must proceed with caution as the rally moves into a second decade. There is concern that an increasing number of fund managers piling into and expanding their presence in this area could drive questionable securitizations to meet their demand. But it’s possible to see where underwriting standards may be slipping, says Clay Degiacinto, CIO of Axonic Credit Opportunities, by looking at the loans that make up a securitization, He also says performance can likely be sustained by steering clear of credits backed by student loans and subprime auto loans along with collateralized loan obligations, and newly issued residential and commercial mortgage-backed securities. More-traditional credit funds accounted for 13 spots in the review of 60 funds, with strategies ranging from long/short and opportunistic to distressed and relative value, which targets mispricing between related securities. Multistrategy success Multistrategy funds, which have perennially underperformed in the hedge-fund industry, had eight funds on the list—the third most of any strategy, tied with equity funds. Segantii Asia-Pacific Equity Multi-Strategy focuses on relative value and opportunistic trades that have helped the fund deliver annualized returns of 17.6% over the past five years. Chief Executive Kurt Ersoy says the fund excelled last year by having low market exposure and with further downside protection provided by shorting indexes toward the end of the year when investors were dumping positions. This selloff in turn created investment opportunities when selling pressures subsided. For the rest of 2019, Mr. Ersoy sees renewed investor interest in China driven by continued capital-market overhauls; the country’s “A” shares joining the MSCI Emerging Market Index; and renewed government stimulus. He also anticipates the multiyear expansion of corporate activity across North Asia (including Hong Kong/China, Taiwan, Japan and Korea) will likely fuel compelling relative value and event-driven opportunities. “All the things that worried the market in the fourth quarter last year are still with us,” says Hanif Mamdani, manager of the PH&N Absolute Return fund, which was up 10.4% over the past five years. While he thinks the Fed’s U-turn on raising interest rates has bought the bull market a few more quarters, he says investors need to cautiously diversify beyond securities that have been performing well. He cites historical research showing the most difficult credit markets come in situations similar to the one we’re in now, when central banks pause rate increases and start considering reversing policy. When this factor is combined with a long rally and various macro concerns ranging from slowing economic growth to expanding trade conflicts, it compels Mr. Mamdani to become more defensive. Macro managers The fourth-largest strategy on the list, global macro, is market agnostic. Managers make long and short bets on key economic gauges, including interest rates and currencies, stock and bond indexes, and commodities. Six such funds made the review of 60 funds. What many macro managers see from their high vantage point is giving them pause. Said Haidar, whose fund Haidar Jupiter gained nearly 11% since January 2014, notes there is “weak data coming in globally, involving auto sales, shipping numbers, machine orders and factory output, and the bond market is recognizing this risk more than equities.” Mr. Haidar’s three largest fears: escalating trade wars, a hard Brexit and Italy deciding to leave the euro. *** Portfolio data that help explain the quality of performance include worse drawdown since 2014—the maximum decline that funds experienced during this time—as well as their five-year Sharpe ratios, a measure of how much risk investors experienced to achieve realized returns. A large majority of the 60 funds reviewed had low to moderate volatility, limited drawdown and attractive risk-adjusted returns. On average, these funds had risk characteristics superior to the S&P 500 while delivering superior returns over the past one-, three- and five-year periods. Also reviewed was funds’ performances since inception, a measure of the consistency of their managers. The measure also shows the managers’ ability to excel across a full market cycle, since about one-third of the funds were launched before the financial crisis. The results were strong: The historical annualized returns of all 60 funds was nearly 13% since inception. Overall, many of these managers share common traits. According to Oliver Newton, head of portfolios at the $85 billion alternative-asset adviser Aksia, such characteristics include “being experienced, astute observers of markets and investor behavior, willingness to challenge convention and think outside the box, commitment to their convictions, and having operations and investor base that support their style of investment.” REVIEW METHODOLOGY Only broader hedge-fund strategies were considered, to discern performance that is linked with manager skills. Funds had to be at least $300 million to help ensure quality of underlying operations. Data was then merged from industry databases, including BarlcayHedge, Preqin and Morningstar. Their numbers are received directly from hedge-fund managers. Virtually all funds that made the list then affirmed the accuracy of this data. All funds on this list that have a presence in the U.S. must report to the SEC. Further, Sol Waksman, who founded BarclayHedge in 1985 (one of the oldest and largest hedge-fund databases), says there have been only a handful of times when clients have reported returns that were materially off from those submitted by managers. “In those cases, we then investigated the discrepancy and if the error wasn’t due to an honest mistake, the fund was delisted,” says Mr. Waksman. Jeffrey Willardson, managing director at Paamco Prisma, says databases are a reasonable starting point for identifying potential hedge-fund investments. “But rigorous due diligence,” he adds, “is essential to verify fund management, operations, investments, as well as return data.” Reviewing funds that don’t report to databases, especially the largest, most-established names, can be difficult. Many managers don’t want their performance data known across the industry. But this review captured some. Mr. Uhlfelder writes about global capital markets from New York. He can be reached at [email protected].