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The Case for (a Few) Hedge Funds
These boast a track record of success and many remain small enough to nimbly navigate a treacherous market.
With their high fees and spotty historical performance, hedge funds are a tough sell for most financial advisors, especially given that investing in them requires heaps of due diligence. However, now seems to be an opportune time for advisors to consider a select group of hedge funds that have delivered excellent returns over many years, yet are small enough to remain agile in a fast-changing and vulnerable market.
Excess liquidity driven by pandemic relief and negative real interest rates are driving this 12-year bull market run. The catch: soaring valuations are not being built upon the backs of rising earnings.
Noted economist David Rosenberg said he is uneasy that the market’s forward PE has climbed from 19, just before Covid-19 was declared a pandemic in March 2020, to a current 23.
Jeremy Grantham, co-founder of the $65 billion global asset manager, GMO, shares Rosenberg’s concerns: “The long, long bull market since 2009 has finally matured into a fully-edged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”
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Whether or not Rosenberg’s and Grantham’s worries are borne out in a month, a year, or two years, is unknown. But history suggests there will likely be a reckoning and if there is, portfolios stand to benefit from flexibility, nimbleness, and creativity. The ability to quickly alter exposure and leverage would be paramount and that is the nature of few funds. Those few, being hedge funds.
In contrast, the paths of most mutual fund managers and exchange-traded funds are preordained by investment style, often tracking benchmarks. Private equity funds and real estate portfolios are also set in their exposure. Other than possibly overlaying some hedges, the directionality of those managers can’t change.
Aswath Damodaran, the NYU Finance Professor RIA Intel interviewed last year, has little faith in active management. “There’s well-established evidence that the more a manager can do, the more damage he or she can do,” asserts Damodaran.
Hedge funds are not a panacea for mitigating market risk. In fact, one could do away with at least 75% of all managers and that would be doing a public service for investors. And advisors should be leery of articles highlighting funds that have soared during the pandemic — they often fail to explore the historic performance of these funds, which in most cases is less than compelling. And some of these highfliers may be new funds with no material track records, often running small portfolios.
However, after tracking the industry over the past 17 years for The Financial Times, Barron’s, The Wall Street Journal, and most recently for the SALT 2020 conference (that didn’t take place), my research suggests there are dozens of consistently high-performing managers worth looking into.
My 2020 hedge fund survey identified the top 50 funds that were running broad strategies and managing at least $300 million for a minimum of five years through 2019. A key threshold that refined this select group of funds: Hurdles that required minimum performance thresholds for specific years.
In 2019, for the survey I prepared for The Wall Street Journal that tracked data through 2018, entry to the list required a fund to have generated at least a 5% return in 2018, when the S&P 500 fell by nearly the same amount. This excluded many mediocre managers.
I not only kept this hurdle for 2018 in my recent survey but also required the same performance hurdle for 2019 — even though stocks soared that year. The reason: some strategies are not geared to the market and demanding a minimum return after fees of the risk-free rate plus several percentage points seemed reasonable.
Key takeaways from the funds identified using this search methodology:
- The average 5-year annualized net return through December 2019 of these 50 funds was 11.26% — more than 7 percentage points a year greater than the hedge fund industry average return.
- The S&P 500 Total Return Index generated 11.7% a year over the same period.
- The 50 funds’ returns virtually matched the market over the past five years and did so with less risk: an average annual standard deviation of 7.8% versus the market’s 11.88%.
- Their average worst drawdown over the same period was -9.1% versus -13.5% for the market.
- The group’s average 5-year annual Sharpe Ratio was 1.84 versus the market’s 0.89.
- The average age of the 50 funds was nearly 12 years, reflecting well-established managers who have proven themselves and are less likely to get slammed or to disappear overnight.
Even more compelling, through September 2020 these 50 funds doubled the returns of the market during the first three quarters of the year and outpaced the average hedge fund by a factor of five.
This market outperformance was achieved by managers who had largely preserved capital when the market tumbled 20% in the first quarter of 2020. The 50 limited losses to less than 8%. And that differential during extreme volatility is how managers (and advisors) can deliver superior returns over plain vanilla market and bond exposure.
A preliminary look at how the top 10 funds from last year’s survey did for all of 2020 revealed remarkable performance. While the market rebounded and ended the year up more than 18%, these managers collectively gained more than 30%.
Why did some hedge funds excel? Eric Costa, global head of hedge funds at the consultancy Cambridge Associates, believes “those who stay faithful to a proven, disciplined, risk-centric investment strategy to generate consistent returns often have the ability to respond to a sudden drastic shock.”
Before an advisor starts considering hedge funds, he or she has to discard the common belief the media perpetuates when it makes broad statements about hedge fund performance — as if the industry is a monolith. That’s where the initial confusion about the industry starts.
Equity long/short is the most commonly known strategy that looks to make money from stocks rising and falling. But there are more than a dozen other distinct broad strategies designed to provide investors exposure to various other facets of the marketplace. They include global macro (tracking broad trends), event driven (seeking catalysts that will move the price of a security), fixed-income relative value (profiting from unreasonable gaps between asset valuations), distressed (finding upside from troubled, beaten-down securities), and multistrategy (combining various strategies).
Hedge fund strategies have evolved to seek different ways to generate independent performance — that go beyond straight long market exposure — to help investors sustain balanced performance across the market cycle.
One repeated takeaway from my years of tracking hedge funds may at first seem counterintuitive.
Successful large funds, including Element Capital, DE Shaw, and Citadel, have strong consistent long-term track records. And most allocators and advisors who have to answer to a board of directors would find safe cover if they invested in such proven giants and performance then turned south.
But what I’ve repeatedly found is that some smaller funds — running less than $750 million, who have been around for more than five years, generating consistent returns with moderate to low risk and whose managers are invested in their own funds — represent a hidden sweet spot. Their size gives them an advantage of being able to invest across the full spectrum of securities, from micro to mega cap, to move their performance needle. They can research more obscure, less covered, and less crowded investments. And they can shift in and out of positions without moving the market. They appear to have the greatest latitude for making critical course adjustments when the numbers and their gut tells them that they’re heading into turbulence and then to alter exposure when the sky is clearing.
The $500 million Millstreet Capital was the top-performing credit long/short fund — ranked sixth in the survey. Based on discretionary, fundamental research, the fund has been generating annualized returns of 10.8% since it launched its high-yield credit fund a decade ago through 2019. It invests in small- to mid-cap companies that the managers get to know very well. Because they entered 2020 being 52% net long, managers Craig Kelleher and Brian Connolly limited first quarter 2020 losses to less than 4.4% as their shorts significantly offset the hit their long positions took. By late spring, they took profits on their shorts and started building up their long book —seeing opportunities in more attractive beaten down opportunities.
Increased long exposure accelerated by mid-2020 after aggressive central bank and government intervention and large banks (primary lenders to these stressed and distressed operations) realized that they would be better self-served by extending maturities, refinancing at lower rates, and maintaining credit lines to help these small- and mid-cap firms survive.
Millstreet pushed up the fund’s net long exposure to 80%. Valuations were further boosted by other investors climbing aboard in search for yield, which sent the prices of most of the fund’s sub-investment grade bank loans and bonds climbing.
By late fall, sensing valuations were getting frothy for an economy that was becoming even more mired in the pandemic, the managers again reversed course, taking profits on their longs and building back up their short positions.
At the end of the year, the fund had gained more than 21% as its net long position settled back down to 60%. And the managers, who are growing even more cautious, expect their net long position could fall back to 50% by the end of the first quarter of 2021 as the pandemic rips through the economy.
Sometimes it helps to have strong convictions in a limited number of investments, regardless of the initial Covid-19 shock portended for the rest of the year.
Clifford Sosin, manager of the survey’s top fund, with $510 million at the end of 2019, believed back in March, “Consumers will go back to work and government will adequately fill in the gap caused by the shut down, and production will recover. I believe what we are seeing is only the temporary idling of our country’s capacity.” He may eventually be proven right. But clearly not yet.
Sosin Partners, an equity long-bias fund launched in October 2012 with an historic annualized rate of return of more than 33% through 2019, got rocked in the first quarter of 2020, down more than 44%. Sosin held steady, and the fund ended up soaring more than 96% by year’s end.
Investment flexibility doesn’t always provide relief. The survey’s eighth-ranked fund was the venerable Renaissance Institutional Equities Fund — a quantitative equity long bias fund that manages nearly $35 billion. It had a trailing 5-year annualized net rate of return of more than 15% and an annualized return rate of 19% since its 2005 inception.
But it ended 2020 down more 20%. It concluded the first quarter down double digits and just couldn’t get out of its own way in spite of the subsequent market rally.
The problem, according to one anonymous Renaissance investor interviewed by Institutional Investor, was “The unpredictable patterns of risk behavior created by the disruption of Covid and the idiosyncratic distribution of stimulus money.” This, he believed, created unprecedented stock price movements, which the fund’s quantitative strategies couldn’t figure out.
The market’s disconnect from the economy is not necessarily a one-way street. With the rules of valuations and investing suspended, there’s no reason why the inverse can’t happen when we emerge from the nightmare that is the pandemic, especially if the market doesn’t like what it sees from a less accommodating Fed and fiscal responsibility returning to policy making.
Advisors and investors interested in hedge funds must keep in mind that due diligence doesn’t stop after an investment is made. As with any investment, one must constantly monitor all facets of a fund’s personnel, operations, and performance.
Email Eric Uhlfelder at email@example.com for a copy of his 2020 survey of top 50 hedge funds, commissioned by SALT. Uhlfelder will be taking part in a webinar on March 9, sponsored by the alternative investment information provider Opalesque, which recently interviewed him.
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