It’s
time to set the record straight. Many members of the media have reacted
negatively to the development that hedge funds will be allowed to advertise to
the general public. A number of outlets have been critical of the hedge
fund industry for some time due to the fact that some money
managers have been accused of unethical behavior like insider trading, as well
as the fact that many billionaires (about 40 to be exact) are hedge fund
managers, somehow asserting that this means they do not need—or deserve—any
additional clients.
In a
gift to these critics, the relaxation of advertising rules comes as the S&P 500 ETF [SPY] has risen
almost 30% over the last two years, meaning that if a particular hedge fund has
only returned 10% per year over this period, it has underperformed the market. This
cut-and-dry comparison makes it easy to poo-poo on the industry at large, but
it’s frankly not that simple.
Yes, hedge
funds indices have, in fact, underperformed the S&P 500 index recently, but
that’s assuming that these indices contain the entire “universe” of 8,000-plus
hedge funds in existence today. In reality, there are plenty of upper-tier
funds that do not report their returns to hedge fund data providers. In
addition, most of the hedge funds do not invest in plain vanilla stocks and
comparing their returns to the S&P 500 index is absolutely absurd.
Many
members of the financial media claim that hedge funds can’t pick winning
stocks. They acknowledge that there are some hedge fund managers who can beat
the market, but no one can pick “good” hedge fund managers before they prove
themselves. Based on these two assumptions they conclude that investors should
stay away from hedge funds. We are going to present evidence to the contrary.
We will also explain why hedge funds invest in Apple [AAPL] and Google
[GOOG] in droves.
Do
Hedge Funds Know How to Pick Good Stocks?
Absolutely,
yes.
We
have a database of all 13F holdings for 92% of hedge funds between 1999 and
2009. According to our calculations hedge funds’ stock picks with market values
between $1 billion and $10 billion outperformed the S&P 500 index by 10.3
percentage points per year (to be exact 82 basis points per month) during this
10 year period. Hedge funds’ large cap stock picks outperformed the market by
18 basis points per month or about 2.2 percentage points per year.
That’s
not the all story though.
From a
consensus standpoint, there is a specific
range of small and mid-cap stocks that gives
piggyback investors the potential to outperform the market indices by a huge
margin. The most popular 15 small-cap stocks among hedge funds outperformed the
market by 18 percentage points during this time period.
Wait,
we know what you are thinking. These results only show that hedge funds were
good between 1999 and 2009. How about the past 12 months?
We
knew this question would be coming a year ago. So, we launched a quarterly newsletter
that picks the 15 most popular small-cap stocks among hedge funds in real time.
We launched this newsletter at the end of August 2012 and have been sharing our
performance since. So how did these 15 most popular small-cap stocks perform
since August 2012?
Much
better. Our picks returned 54.5% through July 30th, vs. a 22.1% gain
for the SPY (see the
details here). This can’t be explained by coincidence. Hedge funds are
amazing at picking winners. We have the historical data and we have been
testing this in real time. Our data confirms this fact.
Can
We Pick Successful Hedge Fund Managers?
The
second myth spelled out by uninformed financial journalists is that even though
there are good hedge funds, there is no way that we can spot them before the
fact. For every David Einhorn out there, there are dozens of unsuccessful hedge
fund managers and we couldn’t know which one is which 15 years ago.
You
know what? This is why hedge fund advertising will be beneficial for investors.
Investors will have access to more information about hedge funds, their stock
picks, their performance, interviews that shed a light on their character, and
they will do a much better job at picking good hedge fund managers.
Picking
good hedge fund managers is actually much easier than you think. If, on the
whole, hedge funds weren’t good at picking stocks (i.e. their performance was
purely random), then it would be impossible to pick good managers. However,
once you know that it is possible to be good at selecting stocks, you will know
that it is also possible to be skilled at finding quality hedge fund managers.
So
far, Insider Monkey has endorsed one hedge fund manager based on the
performance of his past stock picks: Michael Castor of Sio Capital. We even
called him “the next David Einhorn” at the end of March. We also shared his top
stock picks in the same
article. Do you think his picks underperformed the market? Do you
think his picks barely beat the market? Or do you think his picks absolutely
crushed the S&P 500 index?
Castor’s
first pick, Cardinal Health [s:CAH], returned 21.5% since we published that
article. Castor’s second pick, NPS Pharmaceuticals [s:NPSP], gained 76.5%. The S&P
500 ETF’s 8.2% return during the same period was also worse than Castor’s third
pick’s - Anacor Pharmaceuticals [s:ANAC] - 15% gain. Castor’s three picks
averaged 37.7% in four months.
We
then checked in on Castor again in our June newsletter, where he discussed Rockwell Medical [RMTI] and Mazor Robotics [MZOR]. Since
publishing that newsletter on June 10th, Rockwell is up 21.7% and Mazor has
risen 17.2%. The S&P 500 index gained only 2.8% during the same time
period. We don’t think every single one of Castor’s picks can beat the market,
but if you can beat the market 60% of the time, you will have higher returns
than billionaire Warren Buffett.
Are
Hedge Funds Perfect?
Here
is the truth about hedge funds. Their picks beat the market on the average and
their small-cap picks have absolutely crushed the market indices. However,
their large cap stock picks only beat the market by a couple of percentage
points a year.
Hedge
funds’ biggest sin is asset hoarding. There aren’t enough small and mid-cap
investment ideas for all hedge funds. They have so much capital under
management that they have to invest in large cap stocks such as Apple and Google.
The problem is that they usually charge 2% of assets and 20% of profits, and
these fees are generally higher than the excess return they generate by picking
good stocks.
Hedge
funds are taking advantage of investors not because they aren’t good at stock
picking, but because investors don’t ask for their money back when hedge funds
get too big. There are three simple solutions to this problem.
First,
investors shouldn’t pay anything for hedge funds’ beta exposure. Second,
investors shouldn’t invest in hedge funds that focus on large-cap stocks (or
pay ONLY a management fee of at most 2%). The best way of doing that is
investing in small and talented hedge funds like Sio Capital. Third, investors
can do what we do: they can invest in hedge funds’ best stock picks without
paying them a single dime. Our picks have outperformed the market by more than
30 percentage points. I haven’t heard of a lot of hedge funds that have done that
over the last year.
Conclusion
Hedge
funds aren’t that complicated. They are amazing at picking small-cap stocks and
they are good at picking large cap stocks. It is also possible to spot great
hedge fund managers by analyzing their historical performance. The problem is
hedge funds are asset hoarders and they charge exorbitant fees. These fees are
justifiable if they were only investing in small-cap stocks. Unfortunately they
aren’t and this isn’t their fault. It is up to the investors to force hedge
funds to invest in smaller-cap stocks, or to yank their money from hedge funds
and do it by themselves. It is as simple as that.
Disclosure: none
