6 Things You Didn’t Know About Hedge Funds

5. So, hedge funds can’t generate enough alpha in the large-cap space and we know that they have been generating decent alpha until very recently. How did they do that? The answer is very easy but we haven’t seen anyone spit this out in the media. Our research has shown that hedge funds’ small-cap picks outperformed the market by double digits between 1999 and 2009. The 15 most popular small-cap stocks among hedge funds outperformed the S&P 500 index by an average of 18 percentage points per year in the same period. This is a fact, it isn’t an opinion. Unfortunately hedge funds have only a limited number of opportunities in the small-cap space. As they invest a larger percentage of their assets into large-cap stocks, the alpha they generate in the small-cap space wasn’t enough to cover the shortage of net alpha in the large-cap space.

By the way don’t even think for a second that we made a mistake in our calculations. I have a PhD in financial economics and I am quite familiar with these kinds of calculations. Currently we are downloading all hedge fund 13F filings that are filed after 2009 and we will repeat this analysis for recent years as well. Fortunately two years ago we started publishing a quarterly newsletter and shared the list of 15 most popular small-cap stocks among hedge funds with our subscribers in real time. Since the end of August 2012, these 15 stocks generated a cumulative return of 93.7% vs. 47.2% for the S&P 500 ETF (SPY) (see the details here). As you may notice the average annual outperformance of this strategy is more than 18 percentage points per year since August 2012. This result is very similar to what we observed in back tests.