Can outsiders beat the market by more than 20 percentage points per year by imitating hedge funds? We pay close attention to hedge funds because they pay large sums of money to their analysts, consultants, and managers with the goal of uncovering information that can help them beat the market. Some hedge fund managers are corporate insiders because they get themselves elected to a company’s board, or they hold more than 10% of a company’s stock. This gives them additional access to information that most investors don’t have any access. We don’t expect them to pick winners 100% of the time but we expect them to have a few good investment ideas. Our research found out that piggyback investors were able to beat the market by more than 20 percentage points by imitating these stock picks.
How did we pick the list of stocks that hedge funds are most bullish about? If the abnormal returns were around 10 percentage points we would have explained our methodology in detail (read about our small cap strategy that has an annual alpha of more than 10 percentage points). However, these results are extraordinary and we would like to explore it further before sharing it with the public. If you are a qualified institutional investor or a hedge fund, and would like to explore the potential of this strategy, please feel free to contact us.
We won’t be sharing the methodology of the strategy at this point but we will share our quantitative analysis of the strategy. Our data covers the 10 years between 1999 and 2008. We have nearly 1200 dead and alive equity hedge funds in our universe and we were able to obtain 13F holdings for 91% of these hedge funds. This is a preliminary analysis but we will update our results as we finish manually downloading and processing the 13F holdings of the remaining hedge funds. Survivorship bias is a serious problem in piggyback investing. By including all hedge funds (dead and alive) and using point-in-time data we sidestep the survivorship bias problem. The stocks picked by our methodology returned an average monthly return of 1.99% vs. -0.04% per month for the S&P 500 Total Return Index. The strategy beats the market by more than 2 percentage points per month but some of this outperformance is due to its tilt towards riskier stocks. In order to understand the true potential of this strategy we also run a regression using Carhart’s four factor model. Here are the regression results:
Secret Strategy Regression Results (1999 - 2009)
|Variable||DF||Parameter Estimate||Standard Error||t Value||Pr > |t||
In this analysis the holding period for each stock is 3 months. We also included a two month delay for inclusion in the portfolio. The last 13F reporting period in our dataset is the fourth quarter of 2008. The stocks from this period were added at the end of February (giving us ample time to process the filings). Our monthly return data include returns from September 1999 through May 2009. The four factor alpha of our strategy seems to be 170 basis points per month. This is more than 20 percentage points annualized. Our secret portfolio has a beta of 1.25 and slightly tilted towards smaller cap and value stocks. This shouldn’t be too surprising. We don’t expect hedge funds to have a huge advantage over other investors when it comes to mega-cap stocks. However, we think they can uncover potentially very profitable information by researching smaller stocks. Our strategy also has a statistically significant exposure to momentum stocks. Below is a table comparing annual returns. 1999 returns cover September through December and 2009 returns include the first 5 months.
The strategy manages to generate an annual alpha of more than 20 percentage points but we don’t expect such a large outperformance in a real-life implementation. First of all our calculations assume that there are no transaction costs. Our portfolios are reconstructed every quarter; that’s a portfolio turnover of almost 400%. Secondly the strategy’s outperformance is smaller during the second half of the study period. It is possible that the quality of hedge funds’ stock picks may be on a declining trend and this is affecting our strategy’s performance. Finally, it isn’t always easy to implement the strategy as it is designed on paper and this may adversely affect its performance.