Hedge funds were once high-octane, superstar-led investment funds generating double- and triple-digit returns. These days — as journalists lament and investors applaud — many of them are actually pretty boring.

Joseph Edelman didn’t get that memo.



Edelman, 63, founded his biotechnology hedge fund firm, Perceptive Advisors, in 1999. Since then the firm, which started with $6 million in assets, has swelled to $4.1 billion on the back of almost-unbelievable performance in its flagship hedge fund, the Perceptive Life Sciences Fund. That fund, which invests in biotech companies, particularly in the small- and midcap range, has generated annualized gains since inception of 30 percent net of fees — putting Edelman in a rarefied league of high-performing discretionary fund managers.



Last year was even better. For 2017, the fund’s 41 percent gain propelled Edelman to the No. 13 spot on Institutional Investor’s Rich List ranking of the 25 highest-earning hedge fund managers. That performance was the best of any on the list, and netted him a cool $525 million.



What’s more, the fund has posted just two down years since its inception: 2002, when it lost 10.33 percent in a year when the Nasdaq Biotechnology Index lost more than 45 percent, and 2008, when Perceptive lost 23.98 percent, nearly doubling the biotech sector’s loss of more than 12 percent that year. In 2016 — a crushing year for biotech, when presidential campaign rhetoric on drug prices cratered stocks in the sector — Perceptive returned 3.81 percent, versus a nearly 22 percent loss for the sector. This year it returned more than 16 percent through late June.



“They are the best in our business and I think the world of them. Joe is absolutely amazing and he’s got an incredible team there,” says Brad Loncar, a longtime biotech investor and the founder of Loncar Investments, a small family office specializing in the sector that also operates two biotech indexes.



But Perceptive’s astonishing long-term annualized return has come with a hefty dose of volatility — and some questions.



The fund has occasionally posted huge single-month losses, such as its nearly 12 percent drop in January 2016 — and equally volatile single-month gains that sometimes reach double digits (it posted a single-month gain of nearly 69 percent, by far its biggest ever, during its second month in existence).



“Their returns are so spectacular that nobody is in their league,” says one person hugely influential in the allocation of hedge fund assets in the U.S. “The only funds that come anywhere close are activists who really swing the bat.”



Part of this, to be sure, is simply down to the wild world of biotech investing. Perceptive typically shuns big pharmaceutical companies, insurance giants, and hospital chains in favor of small- and midcap biotech companies that develop drugs, often backing the kinds of companies whose fortunes hinge on a single drug that takes years to develop and can be crushed by a Food and Drug Administration rejection.



The hedge fund firm often sticks with its investments for several years — which is how long it takes for breakthrough treatments to go from testing to FDA approval — and isn’t afraid to buy stocks at far higher prices than it initially paid if it thinks the shares still have room to run, or, conversely, to sell shares for much less than it paid if it thinks there is more downside potential. And while the fund is highly diversified, holding upward of 200 positions at a given time, its top-ten positions typically account for half of the fund’s assets.



In other words, it’s a high-conviction, high-risk strategy that’s not for wimps. Which is exactly how Edelman prefers to invest.



“I don’t want to be a hedge fund manager who doesn’t take much risk,” Edelman told Forbes earlier this year. “Otherwise, why am I doing this?”



As Edelman’s star has climbed, so has his asset base. Today the Perceptive Life Sciences Fund manages $3.4 billion. The firm launched its Credit Opportunities division in 2013 to provide debt financing to health care companies it deems innovative and also is set to launch a venture capital fund next month through a partnership with Xontogeny, a startup accelerator founded in 2016 to support promising early-stage biotech companies. Perceptive Advisors now employs 21 people, including 11 investment professionals, and in 2015 moved to slick new headquarters at Astor Place, in the heart of Manhattan’s East Village.



But even as the firm has evolved from small boutique outfit to renowned hedge fund, some would-be investors say the risks are simply too high.



Even the most battle-hardened biotech experts find the sector to be a tough place to make money.



“It is without a doubt the riskiest, most volatile sector in the stock market,” says Loncar. “It’s very difficult even for experts to pick individual stocks. More so than any industry, it’s important to be diversified, because drug development is very difficult. Even excellent companies with great science fail all the time and have big setbacks, because it’s that difficult of a business.”



Of the roughly 500 biotech companies in the U.S., only about 20 are profitable, according to research from investment bank Barclays. These companies tend to focus on a handful of areas — mainly neurology, hematology, and so-called orphan diseases, or conditions that affect fewer than 200,000 people in the U.S. — and try to address unmet medical needs, primarily in the U.S. and Europe.



Geoffrey Meacham, an analyst who heads up coverage of biotech and pharmaceutical companies for Barclays, says the biggest biotech companies these days are closer to pharmaceutical companies in their profiles: They are profitable, have more predictable businesses, have grown more moderately in recent years, and are generally less volatile than others in the sector. But innovation is mainly happening in the mid-, small-, and micro-cap arena, where companies typically aren’t yet profitable and often have a single asset or a pipeline of things in a single area.



“Some of this stuff is 'holy cow,’ Star Trek kind of stuff — that’s why these companies have a little bit of a higher valuation,” says Meacham.



As an example, he cites a company called AveXis, which was recently sold to pharmaceutical giant Novartis. AveXis pioneered a gene therapy approach for the treatment of spinal muscular atrophy — a devastating muscle-wasting disease and the No. 1 cause of genetic death in infants. The potential rewards for such revolutionary treatments are huge — but so are the risks, especially if a company’s drug or treatment doesn’t get FDA approval.



A drug has to pass three trials, known as phases. Drugs that make it to the Phase 3 stage and pass are then eligible to be approved by the FDA. It’s a long and arduous process, and there is a high chance that a drug or treatment will fail after years of trying.



“The ultimate risk in this space is trial failing,” says Umer Raffat, an analyst at Evercore ISI. Indeed, trial failure is often the cause of gigantic one-day losses.



And even if a drug does pass its Phase 3 trial, there is a chance it won’t get FDA approval. Meacham says this is a lower risk than it used to be, in part because the agency is more industry-friendly and has become more transparent. But because most people assume approval following a successful trial, this can also be a potential landmine, Meacham says.



Another risk is simply timing. Meacham notes that hedge fund managers and other professional biotech investors like to buy into these companies before their drugs get to the Phase 3 stage of testing, because by the time they get there, they are already expensive. Savvy biotech stock pickers know that a successful Phase 1 trial can be indicative of possible success in Stage 2, but it’s impossible to get those judgments right all the time, he says. That’s where risk tolerance comes in handy — and where the real money can be made.



“The real high-risk, high-reward part is when you have no idea, no prior data, just a mechanism of action for a certain drug that looks interesting, but you just don’t know” how well it’s going to perform in the trial stage, Meacham says.



“One thing that I think is unique about biotech is you have to get to know the management teams very well,” says Loncar. “You can’t just look at it like a balance sheet and an income statement like you can in some other industries. You have to get to know a management team to know if they are credible, honest, and creating good science.”



As for the sector’s prospects, biotech experts say the Nasdaq Biotechnology Index beat the broader market for several years in a row until 2016, when drug pricing controversies entered the nation’s bloodstream via the presidential election. Raffat says growth has been “anemic” in the large-cap biotech names. But Loncar and others say that amid those headwinds, major innovations are underfoot.



“This is such an exciting time for biotech,” Loncar says. “There’s some new technologies coming along in medicine right now that are disruptive and transformational and very exciting and having a huge impact on patients and society. You have to ride the ups and downs. Biotech is going to go through many peaks and valleys; the valleys can be very stressful and you have to be able to get through the tough times. The only way to do that is to be diversified.”



Meacham says the biotech sector has matured, but he acknowledges that many long-held beliefs about the sector are still true — that companies need a lot of capital, aren’t profitable for years, and can spend a lot of money before suddenly hitting the jackpot, or going bust.



“There are more companies today that fit the bill of more mature, less risky,” Meacham says. “But that’s still a big risk in the industry.”



In addition to the fact that biotech is so prone to wild swings, one prominent investment adviser says his firm passed on Perceptive in part because of the relatively small size of its investment team and the fact that it’s focused on a high-risk sector. “You’ve got [a few] guys putting on hundreds of trades in a risky area,” this person says. “They can produce fantastic returns, but you have heightened risk of them slipping on a banana peel.”

Patrick Morrow, director of investor relations and marketing at Perceptive, responds that the firm believes it is adequately staffed and that the team is equipped to handle the portfolio, given the firm’s consistent strategy and process over the past 19 years and the way the portfolio is structured.



Another person at the prominent investment adviser’s firm says its due diligence revealed other concerns — one of which is the potential for asset-liability mismatches, a hallmark of the 2008 financial crisis that left many hedge fund investors stuck holding investments that fund managers couldn’t immediately liquidate.



Perceptive’s hedge fund offers quarterly liquidity with 45 days’ notice — not unusual for a long-short equity fund, but frequent enough to give this investor pause — and also holds a number of private investments.



“A good chunk of their assets are in very small companies where they represent a huge amount of the float if they tried to trade out quickly,” the person says. “And they had private investments, which they were holding directly in the fund. If you’re 5 percent in privates, it doesn’t seem like a big deal, but if 25 percent of your assets redeem, now you’re 7.5 percent in privates, and then another 25 percent comes out, then you’re 12 percent in privates. We prefer those to be sidepocketed.”



In other words, if a significant amount of fund capital is redeemed at once, the concentration of capital in less-liquid private investments goes up, thereby reducing the overall fund’s liquidity.



Morrow says individual private positions do not constitute a large proportion of assets, are not allowed to exceed a certain size in the portfolio, and tend to be late-stage companies that eventually end up in its liquid portfolio once they have gone public. Simply put, the hedge fund isn’t taking huge stakes in deeply illiquid companies, he says.



He also notes that a third of the firm’s capital belongs to the general partner and that its external investor base has been steady over the years. Earlier this year the fund also raised a big chunk of fresh capital that is locked up for three years.



The investment adviser who passed on Perceptive points out that his firm’s research indicated that Perceptive’s investment team is highly respected on Wall Street. But he says his firm was ultimately nervous that Perceptive lacked the kind of infrastructure his firm typically looks for — all the more important given its focus on a sector that can be littered with landmines, such as failed drug trials or a rejection from the FDA.

But other hedge fund industry veterans say Perceptive has done an exceptional job managing risk in a notoriously difficult sector, and they praise Edelman’s investment prowess, particularly his ability to size and manage positions and the fact that he often takes a skeptical view of companies that other analysts fawn over.



“He is incredibly well regarded. He’s done a spectacular job,” says one hedge fund founder. As for the concerns about an asset-liability mismatch, this person says such concerns are not unique to Perceptive and may be overblown. “As long as it’s not 30 percent of the portfolio, who cares? If all of [$35 billion multistrategy hedge fund firm] Elliott Management’s investors wanted to pull out, they would have an issue too. You shouldn’t have to hedge against 50 percent of your investors pulling out.”



Perceptive has put certain controls in place to mitigate the day-to-day volatility in the biotech sector. It has a maximum daily loss allowance of 5 percent on long and short positions, a mechanism that prevents the portfolio from getting crushed if a stock faces a bruising one-day loss for any reason, such as a drug trial failure.



In any case, Perceptive’s returns — which harken back to the heady early days of hedge funds — have attracted plenty of fans. The firm charges old-fashioned hedge fund fees to go with those retro returns — a management and administrative fee of 3 percent, plus a 25 percent performance fee, roughly 7 percentage points above the industry average, according to data tracker HFR. But that apparently hasn’t been enough to put off investors hungry for high returns.



Like many biotech hedge funds, Perceptive boasts several MDs and PhDs on its investment team. As it happens, Edelman isn’t one of them — but his attraction to the sector came naturally.

The third of four children, Edelman grew up in San Francisco, where his father, Isidore, was a professor of biochemistry at the University of California at San Francisco. After earning a degree in psychology from the University of California, San Diego, he enrolled in a graduate program in psychopharmacology there but dropped out after just a few weeks, thinking that he didn’t want to follow exactly in his father’s footsteps and that he lacked the patience for research.



By then he had begun to realize that he was attracted to the world of finance. He moved to New York City, where his father had just been appointed chair of the molecular chemistry and biophysics department at Columbia University, and enrolled at New York University’s Stern School of Business. He did accounting work to make ends meet while he was in school, including working as assistant comptroller of the Actors' Equity Association.



After earning his MBA in 1988, he got a job at small brokerage firm Labe, Simpson & Co., followed by stints as an analyst at Prudential Securities and then at Paramount Capital Asset Management for a biotech hedge fund called Aries. In February 1999, he joined First New York Securities, a proprietary trading shop that gave him $6 million to run a managed account. He launched Perceptive as a stand-alone fund in July 1999.



The firm takes its name from the way it analyzes corporate events in the biotech sector, which is rooted in Edelman’s psychological training. “We gain a competitive edge by understanding the ‘perception’ of these events and then only investing in ‘reality’ after conducting in-depth research,” the firm says in a pitchbook for the Perceptive Life Sciences Fund, adding that it uses “careful risk management” to mitigate the volatility around these stocks. “In our view, investment decision biases are the single greatest impediment to generating positive investment returns.”



The fund holds 15 to 20 core positions, which it defines as a position that constitutes more than 2 percent of its overall portfolio, with an average core position of around 5 percent of assets. Its five largest long positions are generally about 25 to 40 percent of the portfolio, while its five largest short positions are 10 to 20 percent. Fundamental shorts make up 95 percent of the fund’s short portfolio. Perceptive also actively uses options for hedging, given the volatility around biotech stocks.



Perceptive focuses on small- and midcap companies, investing 75 to 80 percent of the hedge fund’s assets in biotech companies and the rest in specialty pharmaceutical companies, health care IT firms, diagnostics companies, and firms that make medical devices. But the firm’s bread and butter is development-stage companies that make game-changing drugs.



“We’re superfans of health care breakthroughs,” the firm says on its website. “As scientists, we understand that medical discoveries can have blockbuster impact, and nothing captivates us more than an innovation with groundbreaking potential.”



Such groundbreaking potential often comes with huge upside. Take Neurocrine Biosciences, a position Perceptive has held for several years and its biggest holding at approximately 13 percent of the Perceptive Life Sciences Fund’s portfolio. The company’s drug Ingrezza was approved last year to treat a movement disorder “associated with the long-term use of drugs for schizophrenia.” Neurocrine climbed more than 100 percent last year.



Today the stock trades for nearly $120 per share. Edelman began buying it at $4 per share and kept on buying as the price rose above $90 per share. He correctly concluded that analysts hadn’t raised their estimates enough for the rest of 2017, according to Forbes.

“We are really focused on only looking forward,” Edelman told Forbes. “You have to take your history with the stock out of the way.”

Another home run last year was Alnylam Pharmaceuticals, which showed promising results in a late-stage trial last year for a drug, patisiran, designed to treat a rare and deadly neurological disorder. The stock surged nearly 240 percent in 2017.

Other big positions in the fund’s portfolio as of the end of the first quarter included Amicus Therapeutics, a drug development company that surged 189 percent last year; Global Blood Therapeutics, which is developing a drug to treat sickle-cell anemia and which gained 172 percent last year; and Zogenix, a drug development company focused on treating epilepsy that surged nearly 230 percent last year.

Still, biotech companies can have hair-raising downside moves. One longtime Perceptive holding, Sarepta Therapeutics, is a medical research and drug development company that makes drugs to treat Duchenne muscular dystrophy. Its shares halved in a single day in early 2016 after the company got bad news from the FDA. The stock faced another near-term setback that July, when the FDA halted a study of its Duchenne muscular dystrophy drug. The stock plunged more than 9 percent on the news.

Still, Edelman was confident its main drug would be approved, even though sell-side analysts disagreed. He was proved right, and the stock gained a stunning 119 percent in September 2016 alone when Edelman’s prediction came true.

It returned more than 100 percent last year.

Now that Perceptive has exploded in size, the firm must figure out how to maintain its extraordinary performance record — a tricky feat given that the biotech sector doesn’t have limitless capacity. Edelman told this publication back in 2011 that he didn’t want the firm, then managing a few hundred million, to get to $1 billion for fear it would compromise his portfolio.

“If you want to have these smaller companies have an impact on your portfolio, that changes the picture,” he said at the time. “Over a billion, most of your return gets focused on the bigger stocks.”

One way the firm has appeared to square that circle is by approaching the sector in ways beyond typical equity investing.

In addition to the Xontogeny venture partnership, Perceptive also operates its Credit Opportunities arm, making private investments via closed-end, five-year senior secured direct-lending funds, providing “customized debt financing solutions to innovative health care companies,” according to the firm’s website. The firm is now fundraising for its second such fund, Credit Opportunities II, which looks to allocate $10 million to $100 million per investment. Past allocations have included specialty pharma company Aquestive Therapeutics, VBI Vaccines, medical device maker Sonendo, and in-vitro diagnostic instrument maker Singulex.

One institutional investor says this shift makes sense — and is a more appealing way to invest in the sector than via a long-short equity format. Private investments mean this investor doesn’t have to worry about market liquidity or funding redemptions. This investor is particularly wary of biotech funds that short, given the potential for huge losses if a company a manager is shorting gets FDA approval for a drug the manager thinks is going to fail, for example.

Perceptive’s investors say the firm has managed this risk well due to its use of options, Edelman’s uncanny ability to read the tea leaves that other analysts miss, and his inherent skepticism, which he thinks separates his firm from the pack.



“If you don’t know who the sucker is,” he told Institutional Investor in 2011, “it is probably you.”