The hedge fund industry has shown tremendous growth over the past three decades. And that’s for good reason. People who know how to invest invented this mechanism to extract as much value as they can from their talent. Hedge fund managers enriched themselves by delivering positive risk adjusted returns. Alpha is the term used to measure a fund manager’s stock picking ability. Historically hedge funds delivered high alpha, especially when compared to the mutual funds. This success attracted more and more funds from investors who didn’t want to be left out. As hedge funds assets began to swell, they started to invest in “ideas” that they’re less comfortable with. They also allocated a higher percentage of their portfolio to larger-cap stocks which are relatively more efficiently priced. So it isn’t surprising that hedge funds’ alpha has been on a declining trajectory for the last decade. Some of most recent studies even claim that the average hedge fund today doesn’t have any alpha.
This should be alarming for hedge fund investors. Hedge funds are becoming like mutual funds. Not generating any alpha doesn’t mean that hedge fund managers are losing their stock picking abilities. One reason for that is the adverse selection problem. People with no stock picking ability have enormous incentives to launch hedge funds. If they get lucky, they’ll make millions. If they don’t get lucky, the investors will lose and not them. The second reason is that as assets under management swell, hedge funds now tend to invest in ideas that are not necessarily the favorite. Returns in a hedge fund’s 35th best idea wont usually return as much as the hedge fund’s top ten ideas. This dilutes their alpha and in some cases delivers huge surprises to them. The third reason is that hedge fund managers pocket between 30% and 80% of their total returns. The residual returns after fees and expenses are what investors get and these are the returns that researchers say have no alpha anymore. Hedge funds still generate positive alpha before management fees.
So why do we track hedge funds? Because we want to know the:
Best Stock Picks of the Best Hedge Fund Managers
A typical manager has a small number of good ideas. He’ll give higher weight to these ideas in his portfolios. The remaining positions are large in number but smaller in weight. These positions help fund managers to diversify, deploy more capital, and extract higher management fees. Academic studies have shown that fund managers’ best ideas manage to beat the market by as much as 7 percentage points annually. Our aim is to follow these studies and pick stocks that can beat the market on the average over the long run. Remember- hedge funds still generate significant alpha before expenses. We can imitate hedge funds and avoid paying them a large chunk of our returns. Our in-house research has also discovered several quantitative strategies that beat the market by as much as 20 percentage points annually over a 10-year analysis period (read the details here).