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Barron's Best 100 Hedge Funds: 2015 List

Indexing may be in style, but old-fashioned stockpickers rule our list.

Equities dominated Barron’s Penta top 100 hedge fund rankings for the second straight year on the back of a record-breaking bull market now well into its seventh year. Once again, Larry Robbins’ Glenview Offshore Opportunity fund claimed the No. 1 spot, with an impressive three-year annualized gain of 57%.

Even with the recent gyrations in equity markets, stockpicker Robbins is bullish.

“The market continues to show favorable conditions, including valuations that remain attractive, excessive corporate cash balances, and underlevered balance sheets,” says Robbins. What’s more, he sees corporate executives and boards more open to share repurchases, capital improvements, and acquisitions.

Two other positives: Robbins expects the economy to grow at a solid rate and sees systemic risk ratcheted down by central bank and regulatory policies.

Accordingly, he continues to find opportunities, noting that 40% of his top 20 performers last year were new to his portfolio. For example, he established a 14% stake in the country’s largest operator of animal hospitals -- VCA of inYour ValueYour Change Short position (ticker: WOOF). He sees the industry as defensive, and the shares cheap at 14.5 times 2015 earnings, and expects top-line expansion of 5% to 6% for the business after several years of dormant growth following the financial crisis. VCA is now in the midst of a $400 million share buyback; the company is making more acquisitions, and the stock has soared from $32 to $53 since Robbins moved in just two quarters ago.

The stellar returns of Robbins and others on our Best 100 list stand out in a year when oil prices plummeted, the U.S. dollar surged, the Federal Reserve kept bond investors on edge, and the Cold War suddenly heated up in Ukraine. Such challenges proved difficult for many funds. Many high-caliber firms didn’t qualify for our list this year, including Ray Dalio’s Bridgewater Associates, David Einhorn’s Greenlight Capital, Chase Coleman’s Tiger Global, and Paul Singer’s Elliott Management.

Another measure of the challenging environment: the closure of some venerable fund names, including Dan Arbess’ Perella Weinberg Xerion fund, which had specialized in distressed credit and special situations, and Brevan Howard’s commodity fund. Several macro funds also shut down, including Josh Berkowitz’s Woodbine Capital Advisors, Keith Anderson’s Anderson Global Macro, and Kingsguard Advisors. And Everest Capital shuttered six of its seven funds after being smacked by the Swiss franc. Industry data analyst HFR reported that in all, 864 funds closed in 2014, a slight decrease from 904 the year before.

The Barron’s Penta survey underscores the great disparities in recent hedge fund performance, a source of controversy to investors who pay top dollar and pushed industry assets past the $3 trillion mark by at least one tally last year. According to BarclayHedge, the average hedge fund returned 7.36% annualized over the three years ended in 2014 (our benchmark); the average for our Best 100 exceeded 21%, net of fees, about a percentage point better the average return of the Standard & Poor's 500.

The good news for investors is that the average hedge fund management fee declined to 1.51% from 1.54% last year, while performance fees dropped to 17.8% from 18.2%, says HFR.

Like Robbins, almost half of our best performers invested in stocks. Many are great long-term investors who don’t trade frequently, and others, such as Nelson Peltz’s Trian Partners (No. 87), William Ackman’s Pershing Square (No. 54), and Robbins, use their equity stakes to lobby for corporate changes.

Our No. 2 this year is a stockpicker, Richard Mashaal of Senvest Partners, who registered an annualized gain of 44% on the strength of selections like DepoMedPO inYour ValueYour Change Short position (DEPO), which makes pain-management drugs; videogame maker Take-Two Interactive Software (TTWO), publisher of Grand Theft Auto; and Howard HughesHHC inYour ValueYour Change Short position (HHC), a real estate developer whose portfolio includes the South Street Seaport in New York.

Michael Masters $768 million Marlin fund claimed the third spot by focusing primarily on long equity positions, registering three-year annualized returns of 41.63%.

The fourth-place finisher was Camox. Jonathan Herbert’s fund buys small- and mid-cap European stocks, which few expected to excel when 2014 got under way. “Europe is fundamentally stronger than it’s perceived,” explains Herbert, “and its growth engines -- German, Swiss, Austrian, Northern Italian, and Scandinavian global exporters -- are not only firing on most cylinders but many are now getting an added boost from the cheaper currency.” His winners: Temenos Group (TEMN.Switzerland), a global leader in banking software, and Duerr (DUE.Germany), a major provider of auto-plant engineering and paint systems. Camox scored an annualized three-year gain of 36%.

Credit continued its strong showing with more than a quarter of the Best 100 funds’ strategies focused on debt. Brendan McAllister, co-manager of Pine River Fixed Income, No. 51, said agency-backed residential mortgage-backed securities and commercial mortgage-backed securities were clearly the highlights in his fund’s modest 6% return in 2014. This year, he sees strong potential in structured credit. And he believes that the return of volatility to fixed-income markets, which he says was lacking last year, will enhance opportunities.

So how did Barron’s Penta identify these managers?

We initially screen out narrow industries and small regions, excluding funds that invest in only one sector or country, and we avoid commodity-focused funds. We will include Asian-Pacific funds, for example, but not China-centric ones. Gold or energy funds are omitted, but diversified commodity trading advisors (aka, managed futures) are considered. And to ensure that we are reporting the results of professionally run shops that offer stability and sufficient liquidity, funds must have at least $300 million and a three-year track record as of Dec. 31, 2014.

Our search starts with information provided by three major hedge fund databases: BarclayHedge, Morningstar, and eVestment, which collectively sort through thousands of funds that meet our basic requirements. We also rely on a variety of industry contacts and proprietary sources to track down funds that operate below most radar screens. Funds are then arranged by three-year performance, with each contacted to confirm‎ accuracy of data and strategy. This year’s reporting was assisted by Contributing Editor Michael Shari and Researcher Yue Jiang.

Noteworthy repeat performers on this year’s list include Michael Hintze’s CQS, Ken Griffin’s Citadel, and Steve Kuhn’s Pine River, each of which have made the list four times; David Tepper’s Appaloosa, claimed a spot for the fifth time.

Will hedged equity funds continue their strong performance?

Despite the market’s being only up fractionally through the first quarter of the year, the trend in hedge funds is continuing with equity long-bias and long-short funds up 2.64% and 2.82%, respectively. Global macro has had the quickest start, up 3.79%, nearly matching its return for all of last year. Event driven is up 2.26%; fixed-income arbitrage has climbed 2.25%.

But to thrive for the rest of the year, managers will have to navigate the challenges posed by expanding interest-rate differentials, volatile exchange rates, and continued oil shocks -- which have so far been on the downside. But that could turn on a dime.

Camox’s Herbert, in fact, has turned defensive as his net long position has collapsed from last year’s 95% to 30% during the first quarter of 2015. His long book weight hasn’t changed, but he has ratcheted up his short exposure from 35% to 80%, having loaded up with shorts of the German DAX. But longer term, he remains bullish on Europe.

Senvest has similarly altered its portfolio. It’s maintaining its gross long weight, adding Fiat Chrysler as an ongoing restructuring story, and European financials and real estate investment trusts, including the Bank of Cyprus, Irish Green REIT (GRN.Ireland), Dalata Hotel Group (DHG.Ireland), and Spanish Axia Real EstateAXIA.MC inYour ValueYour Change Short position (AXIA.Spain). But it has boosted its gross shorts from 15% to 50%, including a bet against McDonalds. “We think its best days are behind it,” explains Mashaal, “and no financial engineering can alter the fundamental trends we see.”

With all of the macro rumblings, Michael Hintze, manager of CQS Directional Opportunities fund (No. 60), expects greater return differentiation among asset classes. Keeping his cards close to his vest, he does give a nod to biotech, robotics, and cybersecurity shares. He believes that the dollar will continue its rally, and with European quantitative easing now a reality, the Continent should offer opportunity. But he urges caution for the medium term, should European leaders further defer fundamental change.

Hintze’s multi-strategy approach keeps his options open. But with the persistence of cheap money, the lack of yield except in stock dividends, plummeting energy prices helping to keep a lid on inflation, and loose central-bank monetary policy, equity managers should be poised for another very decent year.

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Lyrical Asset Management의 파트너인 웰링턴, 케스윈과의 대화

Why 33 is the perfect number of stocks to own.

Lyrical Asset Management’s Partners, Andrew Wellington and Jeff Keswin, recently spoke with us about the state of the hedge fund business, the firm’s name, and its investment formulas. Then they offered up some of their favorite stock picks from their top-performing Lyrical U.S. Value Equity hedge fund. Read on.

Barron’s Penta: Hedge fund performance overall has been pretty dismal relative to less-expensive passive index funds for the past few years. What are the implications?

Wellington: I know from running our business that there is a tremendous variety of pools of capital out there -- pensions, endowments, hospitals, high-net-worth and family offices -- that are seeking an attractive rate of return. Unfortunately, the traditional long-only managers have been co -opted by the benchmarks. So people have started going to hedge funds. The hedge fund business has proliferated. You still have excellent firms that are producing gains. But there are so many firms that there is a lot of mediocrity, and that has watered down the industry as a whole.

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How can things improve?

Wellington: This is still a job that requires a lot of skill and intelligence, and there are a lot more funds out there than great fund managers. That doesn’t necessarily change how well the best funds are doing. But the one-thousandth fund that gets launched is just not likely to be as good. You really need to be exceptional to do well.

What advice would you give a high-net-worth investor who is looking to invest in hedge funds? What’s the most important question an investor should ask?

Wellington: How much of a manager’s track record was driven by skill and how much by luck? That’s really the question you want to ask. But it’s easy to be misled. Great managers have bad years, and bad managers can get lucky. It really takes a lot of investigation. Your next best choice is to work with someone like a financial advisor who has access to information and knows how to analyze managers. While that has the downside of adding an extra fee, the upside is that you’re much more likely to pick a good hedge fund.

Are institutional investors making the industry too conservative by setting guidelines for hedge funds?

Wellington: Because institutions have more requirements, not every successful hedge fund strategy is going to suit them. This creates opportunities for strategies that don’t fit institutional mandates to find niches that are very successful. But just because there are limits does not mean there will be restrictions on performance. The best managers recognize that they have skills and talents in a certain area, and they stay within that area. I have strong skills in equity investing, but because I don’t have any skills or expertise in credit, I’m not going to try to add any gains there. So it doesn’t hurt me to be constrained.

Tell us a little bit about Lyrical. Who came up with the name?

Keswin: I did. I had long bifurcated the investment world into analytical and interpersonal. The dictionary definition of lyrical implies empathy, the expression‎ of emotion, and there’s a secondary definition related to enthusiasm. Lastly, I wanted the name to connote dynamism and entrepreneurial creativity and personal engagement.

How do you pick stocks?

Wellington: We sift through our universe of the 1,000 largest stocks in the U.S. and find the best ones to build a diversified portfolio of 33 stocks. We think we can generate returns without taking on the additional risk that comes with smaller-cap stocks. But the way we do that is not from a top-down perspective. It’s not by thinking about where the economy is going or where the market is going. It’s from a bottom-up perspective. It’s from looking at those stocks that appear to be the most undervalued, and then trying to pick those that have the additional characteristics of being good businesses and relatively simple and easy-to-understand businesses.

We value businesses based on their five-year forward normalized earnings. We put a multiple of nine on every stock because that is the historical average for the largest stocks in the market. And nine times five-year forward is equivalent to 16 times one-year forward.

If you’re confining yourself to the most common subset of stocks that there is in the U.S., and if you’re long only, how are you different from any other plain-vanilla fund manager?

Wellington: What separates us is that we are really long-term investors. I don’t think there are statistics like this for hedge funds, but the average mutual fund turns its portfolio over 80% to 90% a year. Our turnover is only 17%. Our average holding period is over six years. In a world where people are chasing shorter and shorter investment horizons, and trading faster and faster, we have gone in the opposite direction and taken a truly long-term view of the businesses we invest in.

What are the merits of your process?

Wellington: The merits of our process are the kinds of returns that we expect to generate, and the tax efficiency. Because we have very low turnover, almost all of our returns are taxed at a long-term capital-gains rate. Because of our long holding period, those taxable gains are not only long-term but deferred for many years. We have a very simple, easy-to-understand process that’s disciplined. It’s repeatable. It’s easy to monitor. We are very transparent.

I realize you’re a bottom-up investor, but does Lyrical take a view on the U.S. economy?

Wellington: We avoid companies whose future outcome is highly dependent on what happens to the broader economy, like deep cyclicals. If we need to get the economy right to get the investment right, then we are not going to make the investment. We look for companies that have a lot more control over their own outcomes and aren’t dependent on what happens to the economy. Now, if we go into a terrible recession, they may make less money for a year or two, but they won’t lose money, and they have it within their power to right the business. Their costs are variable. They are not capital intensive. They can adjust the business to a lower-demand environment and get back to the kinds of margins they used to have.

What are the stocks in your portfolio that fit that description?

Wellington: The companies we own would not get hurt badly in a recession, like cable-TV operator ComcastCMCSA inYour ValueYour Change Short position [ticker: CMCSA], as well as managed-care companies such as AetnaAET inYour ValueYour Change Short position [AET]or Anthemantm inYour ValueYour Change Short position [ANTM]. This isn’t just speculation. We went through a pretty bad recession in 2008. Comcast has grown earnings every single year for the past 10 years, even in 2008 and 2009, because people pay their cable bill through good times and bad. We think it can go about 20% higher. It’s a staple, like health care is for Anthem and Aetna, whose insurance is mostly with companies. We see about 15%-20% gains for them. We have owned all three companies since we started in January 2009 and still like them.

Lyrical owns precisely 33 stocks. Is that enough to spread your risk?

Wellington: When you have 33 stocks, everything is about a 3% position. A 3% position is big enough to make an impact. But it’s also small enough that you can be dispassionate about it. One mistake is not going to kill you. When you run a 10-stock portfolio, and you are talking about 10% positions, one mistake can kill you. There are lots of favorable risk reward investments where the downside might be too scary for you to invest 10% of your portfolio in one of them, but you can comfortably make one just 3% of your portfolio.

You spend a lot of time trying to get earnings projections right. Any stocks in your portfolio where the earnings haven’t come through as anticipated?

Wellington: The only two that have reported real operating losses are Avis Budget Group [R], which reported a loss of 50 cents a share in 2008 and four cents in 2009, and Goodyear Tire & Rubber [GT] in 2009. We still like both and see upside of roughly 30% for Avis and even more, about 75%, for Goodyear.

When is the last time you bought a stock?

Wellington: On Sept. 25 of last year we bought NCR [NCR]. Our screen identified it as a cheap stock. We dived in, researched, analyzed. We came to the conclusion that it was a great business that was being significantly undervalued by the market. It went onto our bench [awaiting a chance to join the portfolio]. It entered the portfolio when a corporate acquisition allowed us to sell a stock.

What do you like about NCR?

Wellington: NCR’s earnings growth is being stunted. In one of its three segments -- checkout systems -- the product is sold to retailers who are now deferring orders because they are having to divert their IT budgets to data security. This is due to the data breaches we have all read about at companies like Target and Home Depot. But this is a temporary issue. They have not lost their competitive positioning. We believe there are good long-term trends for the business, and that five-year normalized earnings will probably be around $4.50 or $5 a share. The consensus estimate is that the company is going to deliver about $2.70 a share this year. We could see it gain 50%.

Seeing as you buy stocks so infrequently, let’s reach a little further back in time and talk about another favorite.

Wellington: We bought Avago Technologies [AVGO], an analog semiconductor maker, in 2013. It makes radio-frequency (RF) chips, for which the end market is smartphones. At the time, there were concerns about growth in iPhone sales, and Apple’s stock price dipped. We liked Avago because more than half of its profits came from non-smartphone markets. They were making optical components that were used largely in servomotors, which are used in any machinery that requires movement, and that business was very stable. Their products had long-term design lives, which gave us more confidence in the long-term earnings power of the business.

Is it still a good long-term deal for investors?

Wellington: Yes, we paid about $38, which was about 12½ times 2014 Street estimates of about $3 a share. That was an attractive multiple for such a high-quality company. We thought earnings were going to double over a five-year period, and that would be close to a 15% annualized earnings growth rate. But they did not earn $3 a share in 2014; they earned $4.90. And this year, they’re expected to earn about $8.50. The company has exceeded even our expectations. In hindsight, we only paid 4.5 times what they’re likely to earn in 2015. It’s an illustration of one of the hidden benefits of owning good companies: Good companies find ways to improve their business over time. We could see it rising 30% more.

Are you ever tempted to break with your discipline and invest more than just 3% of your portfolio in some of these stocks?

Wellington: There is a psychological issue with running too concentrated a portfolio. It’s like flipping a coin in a bet where you’d say, “Heads I pay you $1, and tails you pay me $5.” Those are 5-to-1 odds, and you wouldn’t think twice about taking that bet. But if you make the bet for, say, $1 million and $5 million, you start to think not that the odds are 5 to 1, but that you have a 50% chance of losing $1 million. It’s still a fantastic bet, but you don’t take it because the size of the bet is too big. And I have seen this firsthand as an investor.

Thanks, guys.