Who Are the Hedge Fund Winners and Losers?

Art by Claire Merchlinsky

Everybody likes a comeback story, and the resurgence of hedge funds fills that bill. But with new investments returning to hedge funds, it’s worth asking: Is there a difference in where these funds’ investors put their money?

Some hedge fund strategies are doing dramatically better than others. While all hedge funds have had a rocky start to 2018, in performance terms, the top-returning strategy still is long-short, where fund managers bet on which stocks will rise and which will fall.

What’s the likeliest strategy to come out on top going forward? Maybe not long-short, which is actually centered more on long investments, meaning an expectation that stocks will rise. If the equities environment remains unsettled, however, that could stunt stocks’ appreciation, and crimp long-short funds’ results.

The beginning of 2018 has disrupted last year’s norms, which favored stocks above almost all else: In 2017, the Standard & Poor’s 500 climbed 21.7%, its best showing since 2013. Fears of interest rate hikes and a trade war have chilled equities in February and thus far in March.

To date in 2018, the S&P 500 is off 0.56%, having endured a correction of more than 10% in February. Hedge funds rose collectively by a mere 0.5% for January and February. “In 2017, US equities led the world, but this year conditions have changed,” said Ken Heinz, president of Hedge Fund Research, which tracks hedge funds’ returns.

In light of the stock market’s upheaval, the three other large hedge fund categories could outstrip long-short. Tellingly, the last time long-short was in first place was in 2013, when the S&P 500 romped with a 31.2% return.

The other three hedge fund types are less dependent on the vagaries of individual stock prices. Event-driven funds seek to capture gains from mergers and credit market gyrations, and also natural disasters and political turmoil. Macro funds make wagers on the direction of markets as a whole: bonds, commodities and currencies, as well as stocks. Relative value funds aim to exploit differences in prices or rates of the same or similar assets.

For the first two months of 2018, long-short still was the leader at 1.4%, while event-driven remained at No. 2 with 0.7%, relative value at third with 0.5% and macro in last place with negative 1.3%.

The new uncertainty comes amid encouraging signs for hedge funds overall. In 2017, hedge fund assets rose $59 billion to a record $3.21 trillion, HFR data indicate. Net investment inflow was almost $10 billion last year, a big improvement from 2016’s $70 billion outflow. The turn-around is largely owing to the improvement in returns, which last year averaged 8.6% for the entire hedge fund universe, a heartening step up from 2016’s 5.4% and 2015’s 1.1% loss.

Note that the averages pale before the S&P 500’s, a difference that has been a big spur for hedge investors to head for the exit. Of course, some hedge funds recorded spectacular performances, as much as 10 times what the S&P did last year.

As hedge fund fans are never tired of saying, though, the point of these vehicles is that, rather than attempting always to beat the market, they offer diversification and downside cushions. In 2008, the epicenter of the financial crisis, the S&P 500 was down 37%, a portfolio with a mix of stocks and bonds (60% the S&P, 40% Bloomberg Barclays US Aggregate Bond Index) dropped around 30% and hedge funds lost only 19%.

Here’s how the quartet of hedge fund strategies stack up, listed in order of their 2017-18 (through February) performance rankings:

Long-Short. This category, the largest among hedge funds, has the tightest correlation to the stock market, which makes sense due to its emphasis on the ups and downs of individual equities. In 2008, the touchstone year for bad times, long-short only lost 28%, according to the Chartered Alternative Investment Management Association. That’s compared to the S&P 500’s minus 37%.

One big reason long-short did better than the benchmark: shorting, which in 2008 enjoyed a target-rich environment for betting on declining stocks. Trouble is, the other three strategies did better than long-short in that financial crisis-wracked year, CAIA found.

Should stocks’ woes in 2018’s first quarter extend for the rest of the year, long-short could end up as the anchor man yet again. But punk stock returns don’t always mean long-short will do the worst. In 2015, a blah market year, the S&P 500 inched up a mere 1.4% amid tumbling prices for oil and other commodities. Long-short was in second place then, with a 1% loss, edging out only by relative value (negative 0.3%).

So 2018 is shaping up as a challenging time for stocks, but provided that the year isn’t a complete route, long-short could pull a 2015 reprise because turbulence favors stock pickers. And choosing stocks is long-short’s sweet spot. The past year was one of easy A’s for stock-centric portfolios – all they had to do was ride along with the surging S&P 500, which was goosed by cheap borrowing costs.

A report by Deutsche Bank projects that 2018, when the Federal Reserve is bent on hiking rates perhaps faster than many had expected, “equity valuations will be more reflective of underlying fundamentals, leaving bottom-up stock pickers well-positioned to extract alpha,” meaning returns that out-pace the market.

How much staying power will  good stock pickers have going forward? One possible out-performer: The 2017 long-short leader, SH Capital Partners, which clocked a 234% gain, by the reckoning of the research firm Preqin. The hedge fund is mum about the details of how it accomplished this feat.

Still, in a third-quarter 2017 letter to its investors, Mark Cohen, the head of the fund’s parent, Stone House Capital Management, attributed their success in general to a value approach, finding overlooked gems. The investor missive, published by the Valuewalk newsletter, claimed that since SH’s 2010 inception, it had eclipsed the S&P 500, 29% annualized versus 13.1%.

Event-Driven. Mergers and acquisitions are on the upswing this year, given the robust economy and the swelling cash coffers of corporate and private equity buyers. This year, 73% of medium and large companies plan to accelerate deal making, a survey by the professional services firm Ernst & Young found. Through mid-March, global M&A volume topped $1 trillion, the fastest start on record, Dealogic researchers indicated.

“There will be more transactions, especially in tech, retail and media,” HFR’s Heinz said, pointing in particular to the proposed (albeit endangered) AT&T-Time Warner tie-up and Disney’s plan to buy Fox’s film assets. This is a fraught arena, which can produce headaches when deals come undone. The Trump administration, for instance, is trying to block the AT&T-Time Warner deal.

This category has several sub-sets with their own challenges. Agecroft’s chief executive, Don Steinbrugge, pointed out that the activist hedge specialty – where huge investors like Carl Icahn and Dan Ackman try to force changes in companies – has ebbed of late. “A lot of the bad managers and [excessive] cash on the balance sheet are gone,” conditions that attracted activists, he said. 

After a decent 2017 (up 7.7%), the activist segment turned in the worst showing in the event-driven realm, down 1.5% in January and February. Ackman’s fund, Pershing Square, in February abandoned his short position in nutritional supplement company Herbalife, which he called a pyramid scheme. The company’s stock just kept climbing.

Relative Value. Big Data reigns here, with numbers crunchers out to find mispricing opportunities in securities. The most celebrated such fund has been the Paulson Credit Opportunity, which soared during the financial crisis. It played a smart hand when sub-prime mortgage instruments spiraled to their doom, making founder John Paulson both a savant and a very rich man. While some of Paulson’s other funds haven’t done so well recently, Credit Opportunity has kept up its winning ways, notching an 11% gain in 2017, Bloomberg News reported.

HFR’s Heinz called relative value “the steadiest performer” in a time of low interest rates and volatility and tight credit spreads. If these conditions keep changing in 2018, that could make these funds’ task more interesting, and perhaps harrowing.

One relative value fund that has navigated the landscape well has been EIa All Weather Alpha, which achieved a best-in-category 117% last year. While he couldn’t be reached, fund general partner Andrew Middlebrooks said on his LinkedIn page that it exploited pricing inefficiencies in global equities markets using a quantitative method involving 100 factors.

Macro. Another statisticians’ playground, this category’s quest to find overall market directions has been complicated by central banks’ intervention, designed to rev up slow-growing economies in the aftermath of the Great Recession. For that reason, said Hossein Kazemi, senior advisor at the CAIA, macro has almost always been at or near the bottom in the rankings. The Federal Reserve and its counterparts engineered low interest rates and bought bonds willy-nilly – and the upshot was, Kazemi said, “it threw off the macro funds’ models.”

Now, though, the Fed is going in the opposite direction, and other central banks may follow soon. And that could portend better tomorrows for macro funds.

The trick, Agecroft’s Steinbugge said, is to divine a trend for an asset type and follow it. That has worked out well for macro funds dealing in currencies, commodities, and interest rates, he said, adding that “focusing on trends, not fundamentals” is their advantage.

One example is Portal Capital’s Green Energy Metals fund, which fixes on the metals used in devices meant to lower carbon emissions. Initially, it rode the trend (outside the US) to build nuclear reactors, which by Portal’s definition are environmentally friendly because nukes give off no greenhouse gases. The fund went heavily into uranium, then the 2011 disaster at Japan’s Fukishima power plant happened. Surging uranium prices did an about face. The fund lost money for several years as it unwound its uranium investments.

But it found a new trend: battery technology, used for electric cars and to store wind-generated power. Specifically, Portal began investing in cobalt, a key component of batteries. So Green Energy metals had the best 2017 macro return, at 117%, and thus far in butt-dragging 2018 has logged 10%. “We’re not afraid,” Portal’s marketing director, Forrest Nesbitt, said, “to concentrate on weird stuff.”

And that’s the spirit that has kept hedge funds thriving over time.