How to Beat the Market By Imitating Hedge Funds

Update: (May 14,2013) We launched a newsletter at the end of August 2012 that lists the stock picks of the small-cap strategy discussed in this article. These stock picks returned 44.8% vs. 17.8% return for the S&P 500 ETF (SPY) since we first published our list (as of May 13, 2013). Now, it’s been only 8.5 months and our track record is very short, but we’ll let you test out our newsletter for 30 days, so you can see for yourself.

In this article we will share the details of a quantitative investment strategy that outperformed the market by 18 percentage points annually over a 10-year period. Investors, public, and the media are obsessed with mega-cap stocks like Apple, Microsoft, Facebook, and JP Morgan. We respond to these demands by publishing the 10 most popular stocks among hedge funds. Our research has shown that a portfolio composed of hedge funds’ 30 most popular picks generated an annual alpha of around 2 percent between 1999 and 2009. This 30-stock portfolio also outperformed the market by more than 1 percentage point annually despite being less riskier than the market. This is interesting but the outperformance isn’t that big after accounting for transaction costs and the time we have to spend to implement this strategy. It isn’t a secret that the markets are more efficient when it comes to pricing mega-cap stocks. Hundreds of analysts already look into these stocks, so there isn’t much to uncover that can yield significantly higher abnormal returns.

This isn’t the case when it comes to small-cap stocks. There are a few people tracking small cap stocks and these stocks are less efficiently priced. Hedge funds spend enormous resources on analyzing and uncovering 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.

We ranked stocks with market caps between $1 billion and $5 billion by counting the number of hedge funds with long stock positions in each stock. The top 15 stocks at the end of each quarter had an average monthly return of 140 basis points per month during the 3 month holding period that begins 2 months after the end of each quarter. S&P 500 Total Return Index had an average monthly loss of 2 basis points during the same period. We also calculated the four factor alpha of these 15 stock portfolio. Portfolios with high beta, high momentum, and high small-cap and value stocks exposure historically outperformed the market. A regression using these four factors as explanatory variables tells us whether our outperformance is a result of exposure to these known sources of outperformance. Here are the regression results:

How to Beat The Market By Imitating Hedge Funds

Our 15-stock portfolio has a high beta and tilted towards small-cap value stocks with negative momentum. Regression results also show that our strategy’s four-factor alpha is 120 basis points per month. These are amazing results for a very simple strategy. However year-by-year table of returns shows that the strategy underperformed the market in some years and its excess returns shrank during the last 5 years. Check out yourself (the second column shows the annual return of our small-cap strategy and the third column shows the total return for the S&P 500 index):

1999 5.7% 13.8%
2000 23.7% -8.8%
2001 15.0% -11.8%
2002 5.6% -22.1%
2003 70.0% 28.7%
2004 26.1% 11.0%
2005 29.6% 5.1%
2006 15.7% 15.6%
2007 -3.1% 5.7%
2008 -47.1% -36.7%
2009 39.6% 3.2%

We should note that 1999 data covers the last 7 months of the year whereas 2009 data covers the first 5 months. The strategy significantly underperformed the market in 2008 because of its small-cap tilt and high beta.

You can find the list of most popular small cap stocks among hedge funds in our quarterly newsletter. Investors can track the performance of these stocks by subscribing to our newsletter.

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