Today, Stephen Taub of Institutional Investor’s Alpha published an article titled, “Hedge Funds Lag the Market, But Their Top Stock Picks Outperform.” In the piece, Taub discusses the widely known fact that as a whole, the average hedge fund will likely return less than the S&P this year, as it has since 2009. Although these words are often echoed by many other members of the financial press, they too often follow with a bogus assumption that because the averages perform poorly, hedge funds are thus worthless.
Bravo, Mr. Taub for sidestepping this common trap gracefully. It appears he finally read one of our articles.
In his analysis, Taub writes, “while the average hedge fund is greatly lagging the market, the most popular stocks held by this crowd are faring much better.” How much better? Taub explains IIA analyzed a model portfolio of 21 stocks that most often appeared among hedge funds’ top ten holdings. This group returned nearly 10% during Q2, versus a 6% return for the S&P 500, according to Taub.
Numbers for the first quarter were even better.
In nearly every hedge fund analysis here on Insider Monkey, we explain that piggyback investors have the highest potential to outperform the market by imitating the best picks of the best fund managers, like George Soros and John Paulson (both below), for example.
The broad-based consensus analysis done by Taub and IIA is a start–and is somewhat similar to the strategy behind the Billionaire Hedge Fund Index we made with MarketWatch–but we’d recommend parsing this data down even further.
By “best picks,” we mean small-cap stocks. Our research has discovered that hedge funds’ small-cap picks historically perform better than their larger investments, likely due to the lack of research surrounding lesser known companies.
By “best fund managers,” we simply mean the best ~525 hedge fund managers in the entire industry of 8,000+ funds. An analogy we’ve given before has to do with baseball:
An average MLB hitter typically hits safely in 25% of the times he’s up to bat. If you’re looking to learn how to become a better baseball player, you’d never want to copy a batter that is simply average, hitting .250. You’d be better off learning from the best MLB hitters, like Miguel Cabrera, who hit .330, or Mike Trout, who hit .326 last season. These are the hitters who one should study, just as the best hedge fund managers are the ones that everyday investors should pay attention to.
One other point that Taub brings up is the 45-day delay faced by piggyback investors when mimicking picks from recent 13F filings. He correctly points out that since the second quarter filing date (August 15th), hedge funds’ top picks have outperformed the market. We’ve also discussed the potential reasons behind this phenomenon, but it basically boils down to two things: (1) hedge fund managers can’t always perfectly time the market, and (2) for a significant amount of the time, they’re early into their investment picks.
This analysis explains how a 2-month delay in a backtest of hedge funds’ 30 most popular picks (from 1999-2009) generated a better monthly alpha (19 basis points) than if there was no delay (10 basis points). This means that by following our small-cap strategy, our readers have beaten both the market and hedge funds themselves, aggregately speaking.
We’ll see third quarter 13F filings in mid-November, so check out some historical picks from our market-beating small-cap strategy if you have a chance. You won’t find Apple Inc. (NASDAQ:AAPL) or BlackBerry (NASDAQ:BBRY) on these lists; there are stocks that have performed much better over the past year, like United Rentals (NYSE:URI) and Visteon (NYSE:VC).
Recommended reading:
Why You Should Dump Your Hedge Funds
Challenges With Imitating Hedge Funds
Disclosure: none