Hedge funds are much better investors
than you are made to believe by the financial press. Even hedge fund
indices hide the truth about hedge funds’ amazing talent in picking
winners and losers. I am going to present convincing evidence of this.
However my advice to you is to dump your hedge funds.
The fact is that most hedge fund
investors don’t make as much money as they did in the nineties and the
first half of the past decade, where alpha in excess of 10% was the
norm. Aggregately speaking, hedge funds’ alpha has been in decline over
the past decade for several reasons. They are as follows:
1) A greater level of competition within the hedge fund industry has caused profit margins to shrink.
2) Hedge funds got bigger and started investing in less profitable areas.
3) There are a lot of unskilled hedge fund managers who are trying to get rich by being “lucky.”
4) Equity hedge funds charge an arm and a leg for beta exposure.
However, before getting into the
details about why you should dump your hedge funds, I want to set the
record straight on one issue that has been bothering me for a very long
time.
You may have read maybe a few hundred
articles where the author compares hedge funds’ returns with the returns
of the S&P 500 index. This is a flawed premise. Equity hedge funds
aren’t 100% long, so it really doesn't make sense to compare their
performance to the broader market indices.
The reason is simple. Hedge funds are, well, hedged.
Now, they aren’t usually 100% hedged,
but their market exposure is 50% on the average, and this fluctuates
from year to year as their managers attempt to time market fluctuations.
In order to have a better understanding of hedge funds’ long-only
performance, Insider Monkey created a 30-stock portfolio of the most
popular stocks among fund managers. Between 1999 and 2009, this 30-stock
portfolio outperformed the market by 11 basis points per month and its
monthly alpha was 19 basis points (read the details here).
At the beginning of this year, we
created the "Billionaire Hedge Fund Index" which tracks 30 of the most
popular stocks among billionaires (and it is 100% long). Recently, we
partnered with MarketWatch and co-branded this index as the
MarketWatch/Insider Monkey Billionaire Hedge Fund Index. In 2012, this
index has returned 24.3% vs. 16.0% for the SPDR S&P 500 (NYSEARCA:SPY). That’s an outperformance of 8.3 percentage points.
On the other hand, according to HFR,
long/short equity hedge funds have returned only 6% last year. Isn’t it
obvious that you will be grossly misled if you compare 6% with SPY’s 16%
return?
It should be clear to you, then, that
hedge funds’ large-cap stock picks are marginally better than the
S&P 500 index. However, if you are a hedge fund client you won’t see
much outperformance in this space because you have to surrender 2% of
your assets and 20% of this year’s return to your hedge fund manager. If
he or she was a closet indexer this year, their fund’s gross return
would have been 16% on the long side of their portfolio, but net returns
would have less than 11%.
On the bright side, many academic
studies show that the average hedge fund still generates enough alpha to
neutralize the effect of high fees.
Still, my advice to you is to dump your hedge funds.
Hedge funds can’t generate enough alpha
in the large-cap space to justify their high fees. They invest in the
large caps because they have too much money to manage, and they don’t
want to give up juicy management fees that enable them buy condos on New
York City’s Park Avenue. How do hedge fund managers get away with
murder (i.e. murder of their clients’ assets)?
The answer is simple.
They generate significantly higher alpha
in their small-cap stock investments. Generally speaking, there are
fewer analysts covering the little guys, and these stocks are less
efficiently priced. Hedge funds spend enormous resources to analyze and
uncover data about these stocks because this is one of the places where
they can generate significant outperformance. Our analysis also shows that this is also a fertile ground for piggyback investors.
Between 1999 and 2009, the 15 most
popular small-cap stocks among hedge funds managed to beat the market by
1.4 percentage points per month.
It is not a typo. Reread it.
This outperformance wasn’t due to high risk either. Our small-cap strategy’s monthly alpha was 1.2% per month during this 10-year period (read the details here). This isn’t even the end of the story.
We launched a newsletter at the end of
August that lists the stock picks of this small-cap strategy. Our stock
picks returned 14.3% vs. 2.1% return for the S&P 500 ETF since we
first published our list four months ago.
Our proposition is very simple: dump your hedge funds and imitate their small-cap stock picks. United Rentals, Inc. (NYSE:URI)
has been the most popular small-cap stock among hedge funds since the
end of second quarter. We also brought United Rentals to your attention
on Marketwatch
last June. The stock returned 45% since the end of June. United Rentals
has been our strategy’s top pick and it will stay that way till at
least the middle of February (see the other 14 stocks picked by our
strategy in our newsletter).