In this article we will share the details of a quantitative investment strategy that outperformed the market by nearly a percentage point per month over a 13-year period. Investors, public, and the media are obsessed with mega-cap stocks like Apple, Microsoft, Facebook, and Google. Our research has shown that an equally weighted portfolio composed of hedge funds’ 50 most popular picks generated a monthly alpha of 6 basis points between 1999 and 2012. This 50-stock portfolio also underperformed the market by 7 basis points per month though.
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. Hedge funds know this but they are managing too much money, so they have no other option (other than returning money back to their clients and giving up lucrative fees) but to invest in these mega-cap stocks.
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 have been sharing the stock picks of our small-cap hedge fund strategy since the end of August 2012. Through March 11th, 2015 our small-cap strategy returned 132.0%. S&P 500 ETF (SPY) returned only 52.6% during the same period. Our small-cap hedge fund strategy outperformed the market by 79.4 percentage points over this 2.5 year period.
We have been receiving several questions on a daily basis from our readers, so we decided to share the results of our historical analysis. Unfortunately, our strategy can’t be perfectly replicated using historical data. Our strategy excludes more than half of the hedge funds. Our strategy was using only 394 hedge funds’ stock picks at the end of August 2012 when we launched our newsletter. There were 799 hedge funds in the historical 13F dataset we are using for research. We can’t go back in time and pick and choose among hedge funds without introducing some sort of bias toward successful hedge funds. So, in this analysis we will use the stock picks of ALL hedge funds. This won’t be an 100% accurate representation of our methodology but we’d rather err on the side of being conservative.
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 127 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 gain of 32 basis points during the same 13 year period between June 1999 and August 2012. 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.
Regression results show that our strategy’s four-factor alpha is 80 basis points per month. These are amazing results for a very simple strategy. Please note that the actual version of the strategy that we share in our newsletter outperformed the market by an average of nearly 20 percentage points per year since the end of August 2012. Here are the annual returns of our back test:
|Year||Small-Cap Strategy (Back Test)||S&P 500 Total Return|
We should note that 1999 data covers the last 7 months of the year whereas 2012 data covers the first 8 months. The strategy significantly underperformed the market in 2008 because of its small-cap tilt and high beta. However, it outperformed the market in other bear markets between 2000 and 2002. Here are the annual returns for the actual version of the strategy since the end of August 2012. Please note that we first share the list of stock picks with our subscribers, give them at least 3 hours to trade, and then start tracking the performance of these picks.
|Year||Small-Cap Strategy (Real-Time Returns)||S&P 500 ETF (SPY)|
|2015 (Through 3/11/2015)||3.1%||-0.5%|
We believe investors can benefit greatly by ignoring large-cap stocks and focusing on hedge funds’ small-cap picks. Hedge funds reveal their best ideas in their 13F filings. By sorting through the noise and identifying the best stock picks of the best hedge fund managers, investors can achieve outstanding results.
How Did The Small-Cap Hedge Fund Strategy Do During The 2008-2009 Bear Market?
If you aren’t new to investing, you probably know that no one can consistently beat the market by making long-term stock picks. Our small-cap hedge fund strategy isn’t an exception. It underperformed the S&P 500 Index by a large margin in 2008. This strategy will probably underperform the market in early stages of a market meltdown for two reasons. Hedge funds aren’t 100% hedged. Instead, they try to sell very their long holdings very quickly at the first signs of trouble. For instance, our strategy lost 9.3% in March 2008 when Bear Stearns collapsed, vs. 0.3% loss in the S&P 500 Index. It recovered those losses by August 2008, however, its returns collapsed between September 2008 and November 2008. Hedge funds weren’t allowed to short certain stocks during those days and they were forced to sell even their “best” holdings. A large number of hedge funds were forced to sell because of heavy redemptions and shut downs (this will probably happen again in the future). During this 3-month period our strategy underperformed the S&P 500 Index by 23 percentage points. Check out the performance graph below:
Hedge funds are early sellers during market meltdowns but they are also early buyers during market melt ups. When they have the ammunition, the first stocks that they decide to buy are their “best ideas” that they were forced to sell. Our strategy started to outperform the S&P 500 Index in December 2008. S&P 500 Index continued its collapse through March 9, 2009 but our strategy’s picks declined only modestly. Our strategy’s picks continued their strong come back during the rest of 2009. They outperformed the S&P 500 Index by 3.1 percentage points in January ’08, 9.4 percentage points in February ’08, 8.5 percentage points in March ’08, 2.6 percentage points in April ’08, and 10.7 percentage points in May ’08.
Overall, the small-cap hedge fund strategy returned 97.9% in 2009 vs. a gain of 26.4% gain for the S&P 500 Index. By the end of 2009, our strategy was almost able to recover all of its bear market losses. It was down only 5% whereas S&P 500 Index was still down 20%. We believe this strategy will probably underperform the market in early stages of a market meltdown, but it will probably recover earlier and faster than the rest of the market. Probably the best time to invest in the stock picks of our strategy is when its recent returns look the worst.