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Were Hedge Funds Right about Their Top 10 Picks in Q3?

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As the third quarter has ended, it’s time to take a look back at the past three months and see if the hedge funds were right about their top picks heading into the past trimester. With this in mind, we have compiled the returns of the ten most popular stocks among the more than 700 hedge funds that we have in our database. The average return of these ten stocks stands at slightly above 1% during the third quarter which is 7 percentage points better than the return of the S&P 500 ETF (SPY), which lost around 6% during the same period.

The recent market turmoil did not pass unnoticed for most hedge funds, since many of these most popular stocks had a significant negative return during the third quarter. You probably read about the recent poor performance of Greenlight Capital, Pershing Square, Third Point, Glenview Capital and JANA Partners, but you probably haven’t heard about Sio Capital’s 8.9% year-to-date gains (we track Sio Capital’s moves in our monthly newsletter). Our calculations also show that VHCP Management’s long stock positions in larger-cap companies returned 17.4% during the third quarter (see the third quarter’s best performing hedge funds). The truth is the media loves to cover the misery of billionaire hedge fund managers, and hedge funds, on average, are performing better than index funds this year (I haven’t seen any headlines about this fact).

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Why do we think that it’s important to follow the stocks in which some of the best money managers invest their capital? The reason is simple, we track these stocks in order to benefit from the stock-picking skills and high levels of expertise of the hedge fund industry overall. These investors usually employ complex analysis techniques and commit a lot of resources to identifying their next investment, while their long-term focus allows us to emulate them. However, our research has shown that, contrary to popular opinion, hedge funds’ most popular picks are not their best picks, because even though they carry a lower risk, they are more efficiently priced and don’t have a lot of intrinsic value that smaller investors could benefit from. On the other hand, their top small-cap ideas have performed very well in our backtests spanning through the period between 1999 and 2012 (see more details about our backtests), and showed monthly returns of nearly one percentage point above the market on average. Our strategy that involves imitating the 15 most popular small-cap picks among hedge funds has returned some 118% since August 2012, beating the SPY by around 60 percentage points.

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So, let’s take a closer look at the performance of the hedge funds’ top ten picks, starting with General Motors Company (NYSE:GM), which ranked on the 10th spot with 104 funds from our database reporting positions valued at $5.78 billion in aggregate. These funds held 10.90% of the company’s outstanding stock at the end of June, while over the third quarter the stock lost 8.8%. However, the decline might be viewed as a development that has made the stock more attractive, since General Motors Company (NYSE:GM)’s recently-announced development plans signal more growth in the upcoming years.

The company plans to cut costs and use the savings to develop new vehicles, including an autonomous car, whose first model might be released as soon as next year. The company has benefited from strong sales amid low gasoline prices and a strengthening smart money confidence also suggests that General Motors Company (NYSE:GM) is worth betting on for the long-run. Billionaires Warren Buffett, David Einhorn and David Tepper are among the largest shareholders of GM as of the end of June, while Einhorn, who re-initiated a stake earlier this year, said in his second quarter letter to investors that “there is an excellent chance that GM” could beat the consensus earnings estimates for the current year (see details).

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