How does HedgeFollow Rank Hedge Funds?

Goal of Ranking Hedge Funds

The goal of rankings is to filter 10,000+ investment funds, keeping only the "best" funds whose top positions have outperformed the market. These are the funds that are most interesting to our users.

After all, there are thousands of funds that are not interesting to follow. Either they employ high frequency trading strategies, focus on derivatives, file inconsistently, etc.

Note that HedgeFollow ranks and rates all institutional investors, not just "Hedge Funds". This provides a much larger population from which we can find outperformers.

Furthermore, by rating funds with 0-5 stars, we are able to create groups of funds that are very useful for aggregations. For example, Strongly Outperforming Funds (4+ stars) represent the top 20% of funds. We can aggregate those funds to answer questions like, what are the most bought stocks among them? Most sold? Most held? And many more useful aggregations that you'll find across HedgeFollow.

Criteria for Inclusion in Rankings

To be included in rankings, a fund must generally satisfy all of the following:

• File 13F for 3+ years: This ensures a minimum track record while giving newer funds a chance to compete
• Own 5+ equities every quarter¹: This demonstrates minimum stock-picking ability
• Filings free of significant errors: HedgeFollow's data-quality process will drop funds that violate this

1: Exceptions to this rule are funds that have already established a significant track record, eg. Scion Asset Management. Funds like Scion sometimes clear their portfolios when they are bearish.

Ranking Algorithms

HedgeFollow gives users the ability to choose from 3 ranking methods:

• Equal-Weighted Stocks Performance: Evaluates stock-picking
• Manager-Weighted Stocks Performance: Evaluates stock-picking and allocation
• HedgeFollow Rating: Evaluates stock-picking, allocation, and risk

All 3 methods look at the top 20 stock holdings over the past 3 years¹. The first two methods however, simply use the 3-Year Annualized return to rank the funds. HedgeFollow Ratings on the other hand, use a more complicated criterion described in the next section.

1: Only stock holdings are evaluated. We filter out options, bonds/notes, most warrants, etc

HedgeFollow Ratings

HedgeFollow Ratings assign a number of stars (0-5) to each fund, which we believe best reflects the overall performance of a fund.

Why use HedgeFollow Ratings instead of cumulative returns? Consider the following hypothetical returns of two funds. Both achieved very similar cumulative returns, but the paths they took to those returns are very different. Fund B's cumulative return was a tiny bit above Fund A, but it took a big dive before recovering higher. Which fund would you prefer?

Most investors will choose Fund A, despite the slightly lower cumulative return. This is because the tiny gain in returns does not warrant taking on that much risk/drawdown.

However, if we rank the funds using just their returns, Fund B would come above Fund A, because it did achieve a slightly higher return. Obviously this was a simple contrived example, but it illustrates the pitfalls of just focusing on cumulative returns. The path to the returns is just as important.

HedgeFollow Ratings would assign a higher rating to Fund A, because the algorithm penalizes risk and takes the whole path into consideration.

Risk-Return Trade-Off

The idea of penalizing "risk" has long plagued portfolio theory, leading to an abundance of methods and ratios that seek to quantify the trade-off. While HedgeFollow's algorithm does have similarities to some of those methods, it is based on a new metric that we researched, developed, and found to be appropriate for the nature of data available.

We opted to not use methods from the literature because we found them to either be too harsh, too lenient, or just not appropriate for this type of data. Our quest was to find a rating algorithm that will offer an optimal balance between risk and return, allowing high performing funds to shine while keeping a lid on wild volatility.

Ratings Methodology

Some interesting facts about HedgeFollow Ratings:

• Cumulative Returns matter, the higher the better
• The path of returns matters
• Like the Sharpe Ratio, risk/volatility is penalized
• Unlike the Sharpe Ratio, the volatility penalty is harshened/weakened based on the path
• Like the Sterling ratio, drawdowns are penalized
• Unlike the Sterling ratio, DD penalty is dampened
• Ratings are relative; 4+ stars are top 20% of funds
• Funds must satisfy inclusion criteria to get a rating

Overall, funds with the highest HedgeFollow Ratings will tend to have high cumulative returns which they reached on a fairly favorable path. You can get a gist of how our ratings work by comparing the return charts of different funds with different ratings, and you'll see the merit of using HedgeFollow Ratings over just comparing returns.

Top Hedge Funds

Investing professionals who read the above would quickly realize: It is extremely difficult (and unrealistic) for a fund to consistently show up in the top hedge funds list, for any ranking criteria.

Even after the elimination criteria, you're still competing with thousands of funds, and the moving 3-year window forces a re-evaluation every quarter. The top 1,000 funds are all outperformers, hence climbing to the top of that list is a massive feat.

Having a 3+ star rating means the fund has outperformed 60% of all evaluated funds, and a 4+ rating implies outperforming 80% of funds. Showing up among the top 20 hedge funds however, implies outperforming >99.5% of evaluated funds. And those last few percents to climb are of course the most difficult.

For these reasons, we commend all funds who achieve a good rating. That itself is a good accomplishment.

The Enterprise Plan

A source of frustration for some funds is that all current HedgeFollow rankings use the top long holdings, while some of these funds actually use more complex strategies that yielded higher returns.

We use top holdings because 1- that's the data available, and 2- this method of ranking is what most of our users are interested in. Few of our users are interested in a fund that achieved 100% returns if we have zero insight into how they achieved those returns. After all, the whole point of HedgeFollow is to have insight into what institutions and hedge funds are doing.

On the other hand, some funds have a bigger story to tell, they may want to showcase their investment strategies, objectives, actual track record etc.

To solve this dilemma we're working on the Enterprise Plan. The Enterprise Plan will allow funds to actively maintain a complete profile on HedgeFollow. Upload photos and background info about your leadership and investment teams, add details about your firm: Its history, investment philosophy and strategies, core values, even upload documents or factsheets about your services.

Funds will also be able to see suspected errors in their filings, allowing them to file timely amendments with the SEC. HedgeFollow has already corrected over 1 million errors since inception, and we hope the enterprise plan will inspire better data quality controls in the industry as a whole.

Building all this will take some time but we're actively working on it, so please feel free to reach out with suggestions/comments as we're continuously collecting feedback on this initiative.