Hedge funds are a massive industry, with the whole industry controlling over $3.6 trillion of assets in 2020. However, not every hedge fund outperforms the market or the benchmark index.
Reports show that most hedge funds struggle to beat the S&P 500 index (the market), and only a few outperform the market in terms of returns.
How Do Hedge Funds Work?
Hedge funds are generally structured as a limited partnership or a limited liability company. They have two partners, limited partners and general partners.
Limited partners are the providers of capital, and the general partners are the professionals who manage the capital. Hedge funds usually have a lockup period which imposes restrictions on the investors to redeem their shares.
A redemption usually involves a redemption fee which discourages early liquidation. The capital the general partners provides, gets invested in both traditional and alternative investments and derivatives to maximize returns and diversify the risks.
What Makes a Good Hedge Fund?
A good hedge fund must fulfill the basic three requirements, good and consistent returns, dynamic management, and diversification.
Returns
Returns are probably the most crucial factor for an investor. Considering hedge funds have huge fee structures, investors want to invest in a fund that provides a maximum return at the lowest risk.
Management
The hedge fund manager and the management team are responsible for executing the strategies and conducting the day-to-day operations. A visionary fund manager and a healthy corporate culture within the company are key to proper coordination among the team, which leads to better decision-making.
Risks
Traditionally, the primary motive of investing in a hedge fund is to have a hedged position. Exposure to varieties of sectors, positions and asset classes provides diversification benefits.
A good hedge fund should not offer the highest return but the highest risk-adjusted return.
The 5 Best Hedge Funds
Some old hedge funds have been generating extraordinary returns consistently for decades, whereas some new hedge funds have been outperforming the giants in 2020. Let’s look into a few examples.
Renaissance Technologies (Medallion Fund)
Founded in 1982 by James Simons, Renaissance Technologies is one of the most profitable hedge funds in the world. It is a limited liability company with an asset under management of $92 billion.
The Medallion fund uses quantitative trading strategies, exploiting mispricing in the market and focusing on short-term returns. The Medallion Fund is suitable for investors who are geared towards returns and not fundamentals.
Medallion Fund, like most quantitative funds, rely heavily on mathematical and statistical models which are based on historical data. Though machine learning algorithms are free from human bias and carry out trade efficiently, it hinders their ability to adjust to unique and unforeseen circumstances.
The Medallion Fund has been generating an annual average gross return of 68% and 39% net of management fees since 1988. This feat in itself is unheard of.
The Medallion Fund has risen 72% in 2020 and 9.7% during the first quarter of 2021, outperforming both the S&P 500 index and HFR’s quant index. The Medallion Fund is not accessible to outside investors.
It is available only to former and current partners, and the funds available to outside investors have not been performing as well.
Overall rating: 9/10
D1 Capital Partners LP
Daniel Sundheim founded D1 Capital Partners in July of 2018. With approximately $13 billion in assets under management, D1 Capital Partners is a relatively new but promising hedge fund.
It focuses on a research-intensive long-short equity strategy with a holding period of medium to long term. Apart from equities, it also occasionally invests in private investments.
Investors who are fundamentally driven and looking for exposure into public and private companies may benefit from investing in the fund. The profitability of a fund using a long-short position largely depends upon the management’s skills to identify undervalued and overvalued companies and take a long-short position, respectively.
If the hedge fund manager thinks that the market is more likely to go up than down, the value of the long position may be greater than the value of the short position. If the reverse is true, the manager may choose to have a larger short position.
It generated a return of 86.8% return in 2020, making it the best performing hedge fund of the year. As of 2021, the fund has a portfolio of $20.9 billion.
Overall rating: 8.5/10
Jana Partners LLC (Jana Strategic Investment Fund)
Jana Partners LLC has approximately $14 billion in assets under management. Founded by Barry Rosenstein in 2001, Jana Partners is structured as a limited liability company.
The Jana Strategic Investment fund specializes in long/short “value + catalyst” strategies to identify attractive investment opportunities over the full cycle of market and economic conditions. It takes an activist investing approach whereby a large number of stocks of companies believed to be undervalued are bought.
The companies then try to make necessary adjustments to improve performance. Investors who are into value investing will get good exposure by investing in the fund.
Value investing, for the most part, depends on how accurately the fund manager can pick winners and losers (and not what happens to the market as a whole). This is advantageous because the broader market sentiments do not impact the fund as long as the manager can take a narrow approach.
However, it is risky and puts the entire weight on the fund manager’s ability. Activist investing might also bring issues regarding stakeholder management and corporate governance.
The fund, throughout its operation, has generated an average annual return of 17.4%. Jana Strategic Fund returned 52% in 2019. In January 2018, Jana Partners announced a new fund called JANA Impact Capital. This was in effort to try and expand towards corporate responsibility in leading companies.
Overall rating: 8.4/10
Bridgewater Associates (Pure Alpha Fund)
Founded by Ray Dalio in 1975, Bridgewater Associates is the largest hedge fund globally, with around $102 billion in assets under management. Ray Dalio has generated a profit of approximately $46 billion over its lifetime to his investors.
Pure Alpha is a flagship global macro fund. They look for situations where markets are not in equilibrium using models based on factors such as exchange rates, interest rates, the balance of payments, inflation rates, etc.
Investors wanting exposure to the macroeconomy should look into the fund.
Pure Alpha Fund relies on the fund manager’s ability to recognize the potential impact of major policy changes on the financial market and its portfolio, making it susceptible to human bias and error. The average annual return of the flagship fund is 12% per year, and it has reportedly lost money only three years since its existence.
Apart from the impressive returns, Bridgewater Associates is also known for its culture directed by Dalio himself.
Overall rating: 8/10
Pershing Square Holdings
With approximately $10 billion in assets under management, Bill Ackman’s Pershing Square Capital is a closed-end fund specializing in long-short equity and debt of the public US and non-US issuers. Ackman specializes in finding stocks with the potential for creating value and shorting stocks of companies that are struggling or overvalued.
Pershing Square Holdings under Ackman is one of the best funds for value investors. Its long-short strategy puts a lot of emphasis on the fund manager’s ability to pick value stocks and recognize overvalued stocks. If a fund manager is able to pick a truly undervalued company, one single position can generate massive returns in the long run.
It is important to note though that this fund is exposed to human error and biases. The fund has netted an average return of 19.23% over the five years. And an impressive 70% return in 2020 with 4.6% in December alone.
Furthermore, Bill Ackman is also well known for outperforming the S&P 500 for seven years straight.
Overall rating: 7.9/10
What Kind of Hedge Fund Should I Invest in?
Distinct strategies differentiate one hedge fund from the other. An investor must beware of the strategies hedge funds use.
Most importantly, whether the risks and exposure associated with such strategies will assist them in reaching their investment goals. Therefore, it’s always advisable to seek guidance from a professional financial advisor before investing in a hedge fund.