Best 100 Hedge Funds

Hedge-fund manager Christian Zugel has made a mint in mortgage-backed securities, and he has also been wheeling and dealing in a lot of real estate. He has had to figure out how to fit a growing staff of 73 into a renovated garment factory, originally built by a grandfather of former Disney Chairman Michael Eisner near the Jersey shore in the town of Red Bank. Zugel also has moved into bigger quarters in London's Hanover Square, and is in the process of doubling his space in Shanghai, so his firm, Zais Group, can broaden its research and investor base around the world.

Zugel's flagship fund, the $462 million Zais Opportunity fund, is No. 1 on Barron's Hedge Fund 100 ranking for the second consecutive year, the first time any fund has posted back-to-back wins in the eight-year history of our tally. Playing a variety of mortgage- and asset-backed securities as well as collateralized loans, the Stuttgart, Germany, native, 53, posted remarkable three-year annualized returns north of 50% through Dec. 31, 2012, nearly five times better than the Standard & Poor's 500 and 13 times better than the average hedge-fund return in that time. His firm oversees $5.4 billion in all.

"Mispricing triggered by the financial crisis set up a great run for us," says Zugel, who once ran high-yield trading at JPMorgan.

 

He wasn't the only beneficiary. The revived housing market has helped drive big returns for a number of hedge funds (see the strategy returns at right). Top-performing MBS shops occupied four of Barron's first 15 spots in our Hedge Fund 100: Deepak Narula's Metacapital Mortgage Opportunities (No. 5), Don Brownstein's SPM Core (No. 9), and Russell Jeffrey's Providence MBS (No. 15) all scored big. Although not, strictly speaking, a mortgage specialist, Copenhagen's Asgard Fixed-Income fund, run by Morten Mathiesen, primarily invested in Europe's more secure covered bond version of mortgage-backeds last year, finishing at No. 8.

Non-real-estate asset-backed securities have also been delivering impressive gains. (Like MBS, their income comes from pools of payments, but from credit-card or auto-loan debt, among other forms.) This group was led by London-based Chenavari-Toro Capital fund (No. 3), which returned more than 46.54% over each of the past three years, and STS Partners (No. 7), whose returns averaged more than 28%.

In contrast to the many secured credit investors near the top of our list, the only long-short equity fund in the top 15 was ValueAct Capital Master, which averaged a 25.20% gain per year, good for No. 11.

THE STRONG RETURNS in MBS and ABS funds helped power the whole Hedge Fund 100. Overall, it delivered an average gain of 17.42%, versus the BarclayHedge average annualized return of 4.30% and S&P 500's 10.87%, as well as the Barclays US Aggregate Bond index, which returned 6.19% a year. (BarclayHedge is unrelated to the Barclays bond index.)

What distinguishes this group from their peers? Stellar returns over time, for sure. But top funds also have "excellent people, management incentives strongly aligned with investors, a disciplined process, a focus on risk and portfolio management, and a culture of innovation," says Kent Clark, who runs over $22 billion as chief investment officer of hedge-fund strategies at Goldman Sachs Asset Management. Just as important, Clark adds, is that managers continuously refine their investment process as market conditions evolve.

Barron's Hedge Fund 100 tries to identify these consistent performers. To make sure that doesn't mean simply operating in a hot industry or region, we exclude those that invest only in a single country or sector as well as narrower asset types such as commodities. So we will, for example, include a fund that invests in Asian stocks, but not one that focuses on Chinese equities alone. To target professionally run shops that offer stability and adequate liquidity, we require that funds run at least $300 million, and we assess returns over three years, instead of just one.

Our research starts with screens prepared by two hedge-fund databases, BarclayHedge (barclayhedge.com) and Morningstar (morningstar.com), which sort through thousands of funds to meet our basic criteria. We then contact the managers to verify their results. With the help of Barron's Contributing Editor Erin E. Arvedlund, we also tapped additional trustworthy sources for performance or other information that was hard to come by.

A few names stand out for consistency over time: David Tepper's Appaloosa, Ray Dalio's Bridgewater, Ken Griffin's Citadel, Michael Hintze's CQS, D.E. Shaw, Guggenheim, Steve Kuhn's Pine River, and yes, Steven Cohen's SAC, have been part of the Hedge Fund 100 several times.

One measure of how tough it is to excel: Only about 40% of last year's funds made this year's list. Another sign: Fund liquidations continued to rise from a postrecession low of 743 in 2010 to 873 in 2012. That despite net flows and appreciation of hedge funds of more than $244 billion in 2012, pushing industry assets above $2.25 trillion, according to data compiler HFR. That's a 60% gain over year-end 2008's $1.4 trillion.

WILL 2013 END the dominance of structured-credit managers like Zais? Their strong returns in 2011 and 2012 pretty much assure most a position in next year's tally, but their relative strength is likely to wane a bit in 2013.

So far through April, all fund strategies are significantly trailing the S&P 500's nearly 13% gain, though asset-backed securities and equity long-bias are neck-and-neck, with returns of 7.41% and 7.18%, respectively. The most noteworthy gainers so far have been global macro, which has risen 4.59%, and distressed securities, whose 6.84% return already exceeds its trailing three-year annual return after just four months. And returns on MBS have come back to earth, with 4.44% through April, according to BarclayHedge.

Russ Koesterich, global chief investment strategist at BlackRock, thinks foreign developed and emerging stock markets will beat the S&P 500 for the rest of 2013. Interest rates should start heading higher in the U.S. once the Fed, as it began to do recently, signals more consistently that it's going to inch away from its easy-money policies, says Koesterich, whose firm runs $3.8 trillion and has three hedge funds on our list. Higher rates obviously make it harder for fixed-income securities, including ABS and MBS, to prosper.

 

In the interim, the BlackRock strategist believes the U.S. equity rally will continue to be driven by healthy balance sheets, ultralow rates, and falling oil prices. Koesterich views U.S. megacaps as undervalued. However, international shares are even cheaper than the broad U.S. market, he says. A stronger dollar should also help foreign businesses.

As for highflying ABS and MBS, Zugel concedes that "most of the big mispricing opportunities caused by the financial crisis have pretty much corrected, pushing us to refine our search." Might be a good time to hedge.