Dump Your Hedge Funds and Buy This Stock

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. Our research has shown that hedge funds’ top small-cap picks outperformed the market by 18 percentage points per year over a 10-year period. 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.

Our research has shown that hedge funds have a small edge when it comes to large-cap stock picks and a large edge when it comes to small-cap stock picks. We 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 1.3 percentage points per year and its annual alpha was 2.3 percentage points (read the details here).

At the beginning of 2012, 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 S&P 500 ETF (SPY). That’s an outperformance of 8.3 percentage points.

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 each year’s return to your hedge fund manager. If your hedge fund invested entirely in the Marketwatch/Insider Monkey Billionaire Hedge Fund Index in 2012, its gross return would have been 24.3% but YOUR net return would have been only 17.5%, barely above the S&P 500 ETF’s return.

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 18 percentage points per year.

It is not a typo. Reread it.

This outperformance wasn’t due to high risk either. Our small-cap strategy’s annual alpha was 15.4% 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. During the 5 months between September and January hedge funds’ most popular small-cap stock picks returned 25.4% vs. 7.4% return for the S&P 500 ETF.

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. The stock returned 62% between September and February. 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 or subscribe to our newsletter).

Disclosure: Meena has a long position in SPY.

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