Investors are returning to hedge funds after the sector posted its biggest gains in a decade in a topsy-turvy 2020. But picking which managers will do well this year will not be straightforward.
Having fallen out of love with hedge funds’ sluggish returns during the bull market of recent years, some investors are being drawn back by what some commentators claim is one of the sector’s best years. Clients have been impressed that many funds have been unscathed by the Covid-19 pandemic and its market volatility. Some 45 per cent of investors surveyed recently by the Alternative Investment Management Association and research house HFM plan to increase exposure to hedge funds.
The problem, however, comes when investors have to decide which funds to put their money in. Far more than in most years, being in the right place at exactly the right time in 2020 really determined a manager’s fortunes, rather than an ability to dissect a balance sheet and build a pricing model.
In a rollercoaster year, funds had to face the S&P 500’s fastest descent into a bear market and an eye-watering rebound, as well as the outperformance of expensive stocks with faster growth prospects than more lowly valued stocks.
Whether a fund timed those waves precisely or not has gone a long way in determining whether its managers have been celebrating their biggest bonus or watching their painstakingly-built record being torn to shreds. The gap between the top and bottom-performing hedge funds opened up to its biggest since 2009, according to data group HFR.
For instance, buying Tesla in late 2019 — as Boston-based Whale Rock Capital did — clearly looks like a great decision in hindsight, even though all but the most ardent Elon Musk fans may not have predicted a 743 per cent rise in its share price last year. Whale Rock went on to chalk up a 71 per cent gain in its long-short fund. Conversely, if you had focused on buying cheap stocks, even the world’s best stockpicker would have faced the headwind of a 23 per cent underperformance of the Russell 2000 Value index compared with the Russell 2000 Growth index.
“It’s definitely harder to assess skill at the moment,” said Bruce Harington, head of long-short strategies at Stenham Asset Management, which invests in hedge funds.
With markets moving so quickly, the vagaries of market timing mattered. Take London-based Helikon Investments. After leaving Kairos Investment Management at the end of September, founding partner Federico Riggio wanted to launch his fund as soon as his six-month non-compete clause expired. This produced a launch date of April 1, just over a week after the S&P hit a three-year low — surely one of the most fortuitous times to launch a fund in recent memory. While the firm correctly called the revival in stocks, Mr Riggio admits the timing of the launch also helped. “We were lucky,” he said.
And what should investors make of the awful year some of the hedge fund industry’s most experienced figures had? CQS founder Michael Hintze was for years viewed as one of the top credit traders with a record of double-digit gains before suffering a shock $1.4bn loss last year.
Analysing why managers lost money and whether they can turn it round becomes even tougher for quantitative funds, many of which are viewed as black boxes by investors. Jim Simons’ Renaissance Technologies, possibly the industry’s best brand name, suffered double-digit losses in some funds. Even Winton Group’s David Harding, whose flagship fund suffered its worst year on record, told the Financial Times last year there was “not any single reason we’re doing badly”.
Differentiating between a manager’s skill and luck is an age-old problem. Industry veteran Dixon Boardman is among those who believe genuinely skilful managers will eventually come good, even if they have had a very tough 2020.
“Can clever people become stupid overnight? Obviously not,” says the chief executive of Optima Asset Management. “Will good managers make out in the end? Absolutely.”
Investors who pay funds’ high fees can argue with some justification that it is the manager’s job to navigate markets, whatever the conditions.
But the danger for investors is that picking a manager could easily become more about a call on markets, on value versus growth investing, or even on the future share price of Tesla. More than ever, recent past performance is unlikely to be a reliable indicator of future returns.