The Most Consistently Profitable Hedge Funds Continue to Prove Their Edge

Over the past five years through 2021, the Top 50 hedge funds collectively generated net annualized returns that trailed a red-hot S&P 500 by just several percentage points, but did so with significantly less risk. And like the 2020 edition, when Covid-19 initially struck, release of this year’s survey again collides with a seismic event — a geopolitical shock wrapped around soaring inflation and rising interest rates. But as the group showed two years ago, this year’s crop of funds outperformed the market by more than 7 percentage points through the first quarter of 2022.

Survey Results

BarclayHedge reported that over the past five years through 2021, the average hedge fund in its universe produced net annualized gains of 7.2 percent, with a Sharpe Ratio of 0.86 and market correlation of 0.90. The latter point suggests the average manager’s penchant to invest in securities that move the S&P 500.

The Top 50 funds collectively returned annualized gains that were more than twice the industry’s average over the past five years (15.5 percent), having trailed a raging bull market by just 3 percentage points. In having nearly kept pace with the S&P 500, the Top 50 did so with significantly less risk and low market correlation.

Between 2017 and 2021, the standard deviation of the Top 50 was under 11, while the S&P 500’s was over 15. The 50’s average worst drawdown during the same time was 10.7 percent, while the market’s was nearly double that figure. It’s no surprise that the Top 50’s 5-Year Sharpe Ratio of 1.75 was more than 60 basis points higher than the market’s.

One key reason that allocators are willing to pay hedge fund fees is the promise of receiving attractive returns that are largely uncorrelated to the market. Over the past five years, the Top 50’s market correlation was just 0.32, which generally affirms that these managers are delivering returns largely based on their own wits.

Several more compelling findings: The average age of the Top 50 is 13.5 years — nearly triple the life expectancy of the average fund, and they’ve been generating nearly the same annualized net returns since inception that they have over the past five years: 13.6 percent. Just as important, this rate of return was again achieved with significantly less risk than the market. And two-thirds of the funds on this year’s list also made the 2021 survey, further highlighting the consistency of managers in the Top 50.

Leaders

With the exception of global macro manager Haidar Jupiter and Millstreet Credit (both of which retained their high rankings from last year), this year’s top 10 funds, based on the highest 5-year annualized trailing returns, were equity strategies. They all delivered returns of more than 20 percent a year over that period, topping the market’s annualized gains of 18.5 percent.

Two hedged equity funds that made the top 10 by avoiding large, name-brand firms are small-cap activist manager Legion Partners (No. 6) and G2 Investment Partners (No. 7), which also focuses on smaller firms, sometimes before they come to market. Both funds generated five-year annualized returns above 21 percent.

This year was the first time Skye Global was just old enough to be considered. Launched in July 2016, it grabbed the top ranking. Jamie Sterne’s equity long/short shop generated annualized returns of nearly 50 percent over the past five years, widely outpacing the next top-performing hedged equity manager, North Peak Capital, which maintained its second-place spot from last year by generating annualized gains of more than 34 percent.

Skye Global declined to comment for this survey. But according to regulatory filings, the fund combines quantitative, cyclical, qualitative, and macro analyses, with remarkable success so far. In less than six years, it has amassed $5 billion and has soft closed.

Big returns from major positions, further boosted by leverage, likely accounted for much of the fund’s remarkable gains. According to its presentation, the fund targets gross leverage between 50 percent and 300 percent, and net leverage from 0 percent to 120 percent.

Before starting Skye Global, Sterne was an equity analyst at Dan Loeb’s Third Point, with a focus on the consumer, industrial, and healthcare sectors. His first gig was working as an equity research analyst at Lee Ainslie’s Maverick Capital.

One common trait that this survey has discerned over the years is that funds generating extraordinary returns way above the mean frequently fall hard during bouts of extreme market selling. Concentration and leverage are often key factors driving sharp rises and falls.

So far in 2022, a number of elite hedged equity managers (who didn’t make the survey) have been smacked around, notably BlackRock Emerging Companies, Maverick, and Tiger Global. In contrast, the Top 50 gained nearly 2.5 percent through the first quarter.

Skye Global was down less than 6 percent for the year through March. However, subsequent reporting revealed that the fund lost 24 percent through April, indicating that Skye Global was hurt by heightened volatility triggered by rising interest rates and geopolitical risks that are slowing growth and sending net present valuations south.

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Strategies

BarclayHedge tracks the performance of 20 different strategies, ranging from hedged equity and credit, to event driven and various arbitrage, to structured credit. “While this data provides a broad sense of how individual strategies have been performing over time,” explains Ben Crawford, head of research at BarclayHedge, “they mask the wide dispersion of fund performance within each strategy.”

While looking at a single year of returns can also be misleading, 2021 revealed an extraordinary breadth of strategy performance — nearly 20 percentage points.

This broad look revealed a startling shift. In 2019 and 2020, hedged equity funds, especially equity long-bias, were top-performing strategies. And it’s no surprise that with the market soaring in 2021, equity long-bias turned in its best performance over the past three years, with net gains of more than 17 percent. But distressed securities grabbed the top spot in 2021, turning in gains of more than 20 percent. For the decade ending 2019, distressed was one of the weakest-performing strategies, registering low-single-digit returns.

The pandemic and the subsequent collapse in interest rates proved a boon for the strategy, as struggling companies were able to benefit from the flood of liquidity. The strategy gained more than 13 percent in 2020 and more than 20 percent in 2021.

Also benefiting from cheap and plentiful money were several structured credit strategies. Collateralized debt obligations were the third top-performing strategy, having gained 16.3 percent, and asset-backed securities returned more than 13 percent.

However, mortgage-backed securities, along with other debt-related vehicles, struggled, delivering just 3.4 percent in 2021. Credit long/short, fixed-income arbitrage, credit long-only, and fixed-income diversified rounded out the bottom of the list last year, with returns that were barely in the black.

The Top 50 funds show how much performance dispersion there can be within individual strategies. Like last year’s survey, hedged equity was the leading strategy, representing 15 of the Top 50. They collectively returned 22.5 percent per year over the past five years through 2021, more than tripling the strategy’s return.

The leading hedged equity performers were the aforementioned Skye Global and North Peak Capital. Both were relatively recent launches, in July 2016 and August 2015, respectively. And both profited very well through concentrated investments in key holdings.

Driving the performance of the $1.3 billion North Peak fund, explains co-manager Jeremy Kahan, is “application of private-equity-style due diligence in constructing a concentrated portfolio of 10-12 dynamic businesses trading at attractive prices.” The fund typically targets companies worth between $1 billion and $10 billion that are generating strong free cash flow and high returns on invested capital.

Multi-strategy had the second most funds in the Top 50. The five-year annualized return of these ten funds was more than 12 percent, tripling the strategy’s average gain.

Running $33.2 billion, Citadel Wellington (No. 13) was the largest within the group, producing annual returns of 18 percent since the beginning of 2017. (The fund is one of 15 in the 2022 survey that made the cut in the previous three surveys, all based on the current ranking methodology.)

Turning in the second-best performance was the $7 billion Schonfeld Strategic Partners (No. 21), with annualized gains of 14.3 percent. And the $1.2 billion Boothbay Absolute Return Strategies (No. 22) generated the third-best returns, with annualized gains of 13.9 percent.

Credit long/short funds produced annual returns of less than 3.5 percent over the past five years. However, this strategy had the third-largest number of funds in the survey: five. Collectively, they more than tripled the strategy returns, with gains of 12.4 percent since 2017. And in contrast to the multi-strategy funds’ large asset counts, the three top-performing credit long/short funds were each running less than $900 million.

The top-performer is Millstreet Credit (No. 8). The $814 million fund has made the survey each of the last four years, posting five-year annualized returns of 20.7 percent. London-based Gemcorp I (No. 27), managing $576 million, produced 12.3 percent gains. And New York-based CRC Bond Opportunity Trading (No. 32), running $526 million, delivered profits of 11.3 percent.

Two unusual fixed-income relative value funds made the survey for the first time. Whitehaven Credit Opportunities (No. 26) invests in various municipal credits across the country, from local project and general obligations to authority and state-level paper. Enko Africa Debt (No. 18) invests in a wide range of the continent’s sovereign debt, ex-South Africa. Both funds benefit from the use of relative value trades — targeting temporary mispricing between comparable bonds that managers expect will correct — to generate gains while controlling risk.

Over the past five years through 2021, Whitehaven has produced 12.5 percent net annualized returns; Enko has done even better with yearly returns of more than 16.7 percent. And both funds’ returns were uncorrelated with the S&P 500. It will be intriguing to see how these funds navigate a rising interest rate environment. So far through June, Whitehaven was fractionally in the black for the year, and through May, Enko was down 10.4 percent.

Size

Over the years this survey has frequently found smaller managers making up a large portion of the Top 50. Last year’s survey included 29 funds that were managing less than $1 billion. This year, that number declined to 23. That said, eight of the top 11 funds were managing under $900 million. While many major allocators may stick with large funds, with their well-established research and management teams, to avoid headline risk, Jérôme Berset, head of alternatives at the $181 billion Zurich-based EFG International, also sees merit in looking into smaller funds.

“Such managers with proven track records of more than five years,” explains Berset, “can offer certain advantages over their larger brethren.” They are able to access a much greater part of the equity and credit universe — from mega-cap to micro-cap — and their investments are less likely to affect prices as much as larger funds might. “And with their holdings often distinct from major market positions, [the] performance of some smaller funds tends to have less market beta,” notes Berset.

While several large funds, including Tiger Global and Element Capital, dropped off this year’s list, the 2022 survey still hosts some very big shops. They have helped push up the average fund size from last year’s $3.1 billion to $3.4 billion. Nineteen funds manage between $1 billion and $5 billion, and another eight funds have over $5 billion in assets.

Citadel, which collectively ran nearly $44 billion as of the end of last year, has three funds on the list, with Wellington (No. 13) and Tactical (No. 19) both top 20 performers. Schonfeld’s $7 billion Strategic Partners (No. 21) and $3.9 billion Fundamental Equity (No. 33) makes it the only other manager with multiple listings. D.E. Shaw’s nearly $20 billion Composite (No. 23) and the $17.7 billion Millennium (No. 28) are solid long-term performers. Same goes for the $8.8 billion Hudson Bay (No. 36), $6.3 billion Drawbridge Special Opportunities (No. 39), $19.8 billion Tudor BVI Global (No. 49), and $6.2 billion Segantii (No. 45).

Several reasons explain the increasing size of funds making the survey:

1. Six of the largest funds are multi-strategy vehicles that rely on expandable in-house multi-manager platforms, which allow them to consistently absorb new investor allocations;

2. Data on certain larger funds that had not been accessible became available this year;

3. Some highly successful managers passed their five-year mark in 2021, qualifying them for inclusion in this year’s survey, including the top-ranked $5 billion Skye Global and the $3.9 billion Schonfeld Fundamental Equity; and

4. Some very successful smaller managers are getting bigger due to appreciation and greater investor interest. Second-ranked North Peak Capital, for example, saw its fund expand from $823 million at the end of 2020 to $1.3 billion by December 2021.

Risks and Opportunities

The sharp rise in volatility and uncertainty — the common theme that threads through manager and allocator interviews — has produced bifurcated responses.

Many have turned increasingly cautious, evidenced by the general reduction in leverage and net exposure. But recalling F. Scott Fitzgerald’s quip, “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function,” some of the shrewdest managers are profiting from disruption triggered by rising interest rates and commodity prices and falling stock and bond indices.

Case in point is the $44 billion hedge fund group Citadel. Its three leading funds, all in the Top 50, have turned in strong first quarters, while the S&P 500 lost 4.6 percent. Multi-strategy Wellington was up nearly 5 percent, quantitative equity Tactical climbed more than 6 percent, and the macro-oriented Global Fixed Income delivered gains of nearly 10 percent — all while the firm’s founder is keenly aware of risks that lie ahead.

Citadel’s Ken Griffin thinks recession is inevitable, triggered by high inflation and the need to bring interest rates up sharply. He explains that doing so will cut into the very high net present value of growth stocks, whose valuations were significantly predicated on cheap money. “With real interest rates turning positive,” says Griffin, “corporate profits will also decline, and this eventually leads to cost cutting and layoffs that will eventually slow the economy and lead to recession.” In this environment, he sees value shares holding up better than growth.

If U.S. growth does indeed stall, David Kelly, chief global strategist at J.P. Morgan Asset Management, thinks a recession will probably be far milder than those that were brought on by the Financial Crisis and the pandemic. “It would likely be deep enough to mop up inflation pressures and curtail job openings,” posits Kelly, “but not bad enough to damage the long-term prospects of the economy overall or most companies operating within it. In time, growth would resume, margins would recover, and markets would rebound.”

But Paul Tudor Jones thinks we’re in for more challenging times, “where simple capital preservation is the most important thing we can strive for.” Jones is clearly referencing the hazardous simultaneous decline in equities and bonds — something markets have never seen before.

Since the 1960s, according to the $151 billion asset manager Man Group, “there have been 44 individual instances of the S&P 500 Index enduring five or more consecutive down weeks. Since 1973, U.S. Treasuries have had 31 such losing streaks lasting at least five weeks. “Yet these prolonged sell-offs,” Man observes in a recent note, “had never coincided — until the start of May.”

This disconcerting alignment is also a big deal to EFG’s Jérôme Berset. “These trends,” he explains, “are telling us markets are bracing for slowing growth while central banks have little choice but to tighten monetary policy to break the current inflation spiral.”

Berset thinks the collision of these opposing trends will generate significant dispersion. “Digging deeper into sectors, industries, and individual companies can tell a different story — some worse, others better,” explains Berset. “Such differentiation creates idiosyncratic opportunities that passive investing won’t be able to pick up on.”

Thinking this is more than markets adjusting to various stresses, Berset believes “we’re entering an inflection point triggered by Covid, war, and rising interest rates [that] collectively will challenge the efficacy of traditional ETF passive investing in long equity and bond indices.”

Berset argues that this is making the case for alternatives that can better navigate the strong trends that are hitting both stocks and bonds by “identifying positions that will benefit from the shifting macroeconomic landscape both regionally and globally.”

Toward that end, he’s combining systematic CTAs and discretionary macro managers alongside market neutral, event driven, relative value, and distressed strategies, to better handle the turbulence we’re heading into while delivering consistent absolute returns.

Dispersion on a more global level will also be enhanced by diverging monetary policies, according to Nathanaël Benzaken, head of alternatives at Paris-based Amundi, which manages €2 trillion. He oversees €20 billion in hedge funds.

Although inflation is now running high in both Europe and the U.S., Benzaken thinks that the impact of war, along with slower European growth, is resulting in distinct monetary responses by the ECB and the Fed. While he believes Europe and the U.S. will experience sustained interest rate hikes, he also feels that there will be a disconnect between European Central Bank and Fed behavior. With ECB Deposit Facility Rates currently at negative 0.50 percent, he doesn’t project overnight rates to turn positive this year.

To help drive uncorrelated returns in this increasingly challenging environment, Benzaken is also relying on CTAs and discretionary global macro managers. And to exploit growing dispersion, he’s also targeting special situations, merger arbitrage, credit, and relative value managers.

The European Central Bank’s unclear response to inflation “is confirmation [that] the war has further delayed European recovery,” according to Filippo Casagrande, head of Insurance Investment Solutions, with €2.5 billion in hedge fund investments at the €585 billion Generali Asset and Wealth Management. He believes that after the current spate of negative news filters through continental shares, Europe may become a compelling investment destination.

But until then, Casagrande is directing new money into the U.S. “While the U.S. isn’t immune [to] the slew of negative global forces, the country appears to be best positioned to weather the current turbulence, especially since its economy was already rallying before the war started, is largely energy independent, and is far more removed from the fighting.”

[Note: In early June, well after these interviews were conducted, ECB President Christine Lagarde surprised markets by suggesting a more aggressive monetary stance. She signaled that near-term rates could rise by as much as 75 bps. That would be 50 bps more than had been anticipated.]

BlackRock’s CEO sees another systemic factor that will further drive inflation and interest rates. Larry Fink believes that the Russian invasion of Ukraine may be triggering “an end to the globalization we have experienced over the last three decades.” He fears this will leave many communities and people feeling isolated and looking inward, exacerbating “the polarization and extremist behavior we are seeing across society today.”

Generali’s Casagrande also sees increased movement toward deglobalization. He fears that this will not only drive prices higher, but could eventually lead us toward the hyperinflation of the late 1960s and 1970s. If economies trend in that direction, Casagrande says it would fundamentally alter investment analysis and selection.

While we’re not there yet, Casagrande continues to de-risk his exposure. He’s targeting low-to-negative correlation to both equity and bond markets through event driven, credit long/short, volatility trading, and market neutral managers.

Cédric Dingens, head of investment solutions and alternative investments at the CHF11 billion Swiss-based NS Partners, sees any material move away from globalization as a major risk to the world’s second-largest economy. “This would be on top of the negative effects of China’s Zero-Covid policy, the possibility war-related sanctions morphing over to the mainland, and leadership’s decision to delist companies from foreign exchanges, which is further reducing liquidity and increasing uncertainty about the Chinese experiment,” he explains. Dingens has reduced exposure to the region. “We need to regain greater transparency before we commit more resources to the country,” he says.

Danish economist Lars Christensen is a bit more sanguine, believing that the war in fact makes the argument for globalization. “Had the world not been so integrated,” says Christensen, “then our ability to meaningfully respond to such a crisis would have been limited. This war in fact shows how risky it would be to decouple from global trade because it would give up leverage in dealing with a crisis.”

He also thinks that Russia’s senseless invasion has highlighted the need for companies and nations to focus more rigorously on governance, especially where it pertains to international investments. He believes this greater awareness should lead to shrewder geopolitical decision-making and alliances, rewarding more benign governments.

So Far in 2022

As allocators hoped, the top-performing funds during the first five months of this year have been trend-following strategies. These include global macro and diversified commodity trading advisors that are latching onto the strong moves in interest rates, bond and stock indices, commodities, and exchange rates.

BarclayHedge reports that through May, global macro and CTAs have climbed 8.5 percent and 8 percent, respectively. Several global macro funds in the Top 50 have generated the strongest returns in the first quarter. John Street Capital (No. 29) was up nearly 9.5 percent, while Citadel Global Fixed Income (No. 34), whose execution relies substantially on global macro calls, rose nearly 10 percent.

But the standout has been the unnervingly cosmic performance of Haidar Jupiter, which has realized gains of nearly 150 percent over the first three months of the year, likely by turbocharging these strong trends with substantial leverage. (The fund refused to comment for this report.)

Emerging market funds were hit the worst, off by 11 percent. However, the two such funds in the Top 50 managed better through the first quarter. Asia-focused FengHe (No. 16) was down 7.6 percent, while Waha MENA (No. 15) gained more than 4 percent. Even the frontier market Enko Africa Debt fund limited losses of 3.6 percent.

Current Thinking

Voss Capital (No. 9) has generated 20 percent annualized returns since its launch more than a decade ago. Hedged equity manager Travis Cocke acknowledges the risks brought about by high inflation, rising interest rates, supply chain problems, and war. But his take is more benign than most other PMs.

He prefers investing when the Fed will no longer intervene by cutting interest rates. This forces stocks to be increasingly priced more on their own merits, says Cocke, “creating a more realistic market environment with increased volatility enhancing bottom-up stock selection.”

The manager sees attractive opportunities in select value and growth shares due to the “market overreacting to rising interest rates, especially given how low they were to begin with.” He still sees high levels of profitability, relatively low leverage, and solid free cash flow, and he thinks that investor expectations are overly dour considering the generally healthy state of consumers and the economy.

Night Owl (No. 5), which has been around since 1994 and has generated annualized returns of more than 14 percent, is responding to the growing financial stress by raising cash.

CIO and PM John Kim has significantly outperformed the market not by altering net exposure and leverage, but by getting out of many stocks when there’s high systemic risk. This has helped his equity long-only fund consistently outperform markets when they are down.

He went to 80 percent cash during the height of the Great Recession. And at the end of May, half of his book was in cash. His current thinking: “Fed policy, seeking to reduce demand, will bring down earnings and multiples that were way too high.” When Kim sees better risk-return rewards and less lofty earnings expectations, he will start redeploying cash into both previously held positions and new opportunities.

While highly priced growth shares have sold off the most during the first half of 2022, the next most exposed canary in the mineshaft is junk bonds. After years of being supported by very low interest rates and quantitative easing, which have collectively compressed spreads, sub-investment-grade bond risk is now showing.

Millstreet Capital partner Jeffrey Growney, whose eighth-ranked credit fund generated annualized returns of 12.4 percent since its launch more than a decade ago, sees stress building in this space in which his fund invests. “Spreads between 10-year Treasuries and junk bonds had held fairly steady around 375 bps, even after the Fed’s initial rate hike this year,” he observed. But with the Fed turning more hawkish in the face of unrelenting inflation, and with recession fears growing, spreads have pushed out to 475 bps and are likely to widen further as the financial conditions of these highly leveraged companies deteriorate.

Growney observes that default rates have already increased from an extremely low 1.5 percent to 2 percent, and he wouldn’t be surprised if they eventually surpass the secular average of 5 percent. “With the June CPI numbers showing no letup in inflation across the board,” Growney expects “things could become very ugly as we head toward recession by the end of the year.”

This is evident in the S&P U.S. High-Yield Corporate Bond Index, which has lost more than 10 percent in a little more than five months in 2022. With little reason to believe that the fallout will decelerate as interest rates continue to rise, junk bond investors may be looking at a 20 percent decline by the end of 2022.

Millstreet has contained the carnage so far — it’s actually up 1.6 percent for the year through May — by investing in only first-lien positions in firms with hard assets and receivables, avoiding covenant-lite obligations, buying short duration, and reducing net exposure from 60 percent to 50 percent. The fund also hedges by shorting weaker corporate debt in the same industries in which it has long exposure.

As debt matures, the fund is raising cash, reducing the current risk of capital depreciation, and eyeing potentially more attractive opportunities as this part of the market cycle plays out.

The Other Side of Risk

Of all the major shocks impacting economies and markets, several will likely remain with us for quite some time, revealing more extreme risks than once thought imaginable.

Outsourcing by wealthy nations to cheaper foreign economies was a win-win that aligned the interests of various countries, enhancing the prospect of peace and the expansion of more free societies, except when it wasn’t. The concept of just-in-time delivery better matched costs with revenues, except when supply chains broke down. Industrialization has dramatically increased the quality of living standards, but it’s also producing devastating weather patterns. Low equilibrium interest rates have enabled major developed economies to thrive, until they couldn’t. And the rise of authoritarianism, which was thought tractable both abroad and here, is not.

No one knows which challenges may produce fundamental change and those that will eventually self-correct. But no one should believe that the collision of so much trauma, much of which has been building over years and decades, can be resolved in short order or without pain and major adjustments. Markets are imperfect barometers of the economic environment, but they do absorb and reflect change. How investors respond to such fundamental shifts will inform future performance.

Eric Uhlfelder is an award-winning journalist who has surveyed top hedge funds for nearly two decades. This is his 19th annual global hedge fund report and the second consecutive edition published by his firm, Global Investment Report.

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