Perhaps you've heard by now: Hedge funds have underperformed the S&P 500 year to date as the index is up 13% so far in 2013. Of course, hedge funds are often specifically designed to reduce an investor's exposure to the fluctuations of the overall market through long/short or other low-beta strategies, so this is not exactly the most level playing field on which to judge the utility of hedge funds.
In addition, when hedge funds can turn the full power of their research teams on under-served areas of the market, such as small cap stocks, we've shown that, far from being chronic underperformers, they can actually be excellent sources of alpha.
How can we determine this? Several weeks after the end of each quarter, eachfiles a 13F with the SEC to disclose many of its long-equity positions as of the end of the quarter. We track these filings in our database for a number of purposes, including to help us research investment strategies.
Last summer we found that, on average, the most popular small-cap stocks among hedge funds (measured by the quantity of funds in our database reporting a position) tended to outperform the S&P 500 by 18 percentage points per year.
At this point, we went to work stock picking — identifying which were the most popular small-cap picks based on 13Fs filed in November 2012. A number of these picks were merger targets;is one of those low-beta strategies we've mentioned, as whether or not a deal closes is very weakly related to market conditions.
Let's take a look at the results since the beginning of this year for the five most popular picks which remain publicly traded: United Rentals (URI) is up 16%; Visteon (VC) has returned 34%; Tripadvisor (TRIP) is up 58%; W.R. Grace (GRA) is trading 13% higher; and Marvell Technology (MRVL) has soared 78%. You don't need a calculator to compare the average return of these names to the S&P's 13% gain, but we'll do it anyway: 39.8%. It's fair to note that small-cap stocks tend to outperform the overall market in good times, but still, Vanguard's small-cap ETF (VB) is up only 19% year to date.
Now consider: this portfolio comes from information released in November of last year, based on information about hedge-fund holdings from September. Buying these stocks at the beginning of 2013 would have been a very easy strategy to implement for investors with sufficient capital to buy five stocks and, even with a very substantial delay, would have resulted in a market-beating portfolio. These results are above what we've found to be typical, but demonstrate that strategies based on hedge-fund activity can realistically work.
Then why is it that overall hedge funds aren't beating the market? A few reasons. First, as we've mentioned, hedge funds often hedge by going short other stocks or the overall market in pursuit of absolute returns; they may also pursue more market-neutral strategies, such as merger arbitrage or investing in global macro instruments.
Second, the largest hedge fund positions — particularly for successful funds that raise billions in capital from investors — tend to be in large-cap stocks almost by necessity. Large caps are more closely followed by large institutional investors and the financial media, and so it is harder to generate alpha in these stocks.
When we looked at billionaire David Einhorn's Greenlight Capital's 13Fs over time, we found that he gets a good deal of his outperformance from small caps (read our analysis here).
Third, of course, investors in hedge funds pay performance fees. There are other reasons less positive for hedge funds as well — for example, a number of funds have been long gold this year, with disastrous results thus far.
Paying heavy fees to invest in a hedge fund is probably not worth it for most investors who don't have to concern themselves with finding investment opportunities uncorrelated with the rest of their portfolio (as many institutional investors do).
However, on average, hedge funds' consensus small-cap picks tend to do quite well. We believe that there are other strategies waiting to be discovered as well, and of course, investors can take advantage of 13Fs and the more up-to-date news from 13D and 13G filings (which occur when a fund or other major investor owns at least 5% of a publicly traded company) to identify free initial investment ideas.