The Truth About Hedge Funds

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 30^th, 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