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Hedge Fund Education Center

Small-Cap Hedge Fund Strategy Back Test Results

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
1999 14.9% 13.8%
2000 -8.5% -8.8%
2001 11.4% -11.8%
2002 -9.8% -22.1%
2003 71.6% 28.7%
2004 28.0% 11.0%
2005 29.5% 5.1%
2006 17.9% 15.6%
2007 -3.4% 5.7%
2008 -52.2% -36.7%
2009 97.9% 26.4%
2010 24.9% 15.1%
2011 -5.5% 1.8%
2012 16.3% 13.7%

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)
2012 14.6% 2.1%
2013 53.2% 32.3%
2014 28.2% 13.5%
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:

IM Strategy in Bear Markets

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.

Who are we?

Insider Monkey is one of the fastest growing financial research websites on the web, read by 1.5 million people every month.

Our research is headed by Ian Dogan who is a former fund manager, holding a Ph.D. in the field. We partnered with Marketwatch and created the Marketwatch/Insider Monkey Billionaire Hedge Fund Index.

Our content has appeared on:

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  • I've been an Insider Monkey subscriber for a couple years now and the flagship strategy is one of the best strategies in my portfolio. Because the strategy is small cap you will see some major short term swings, but if you can follow the strategy and rebalance only once every quarter you will see some really strong results once you hit the 12 month time frame and beyond.
    David L.
  • I initially became aware of Insider Monkey when Meena was interviewed on Business News Network (BNN) in Canada. The idea of mimicking the best ideas from the best fund managers was appealing (as I have met many smart managers on Bay Street in Toronto). While I have only had the newsletter for one year, the Insider Monkey allocation has been the best performer in my equity portfolio. I look forward to continued outperformance in the future.
    G. Chin
    Toronto, Canada
  • I first came across Insider Monkey (IM) nine quarters ago (1/2013) and since then have enjoyed exceptional returns. Last year (3/2014) I traveled to NYC to meet the founder because I was thinking about doubling down on their strategy. I left favourably impressed and proceeded. It was a smart move. At the beginning of this year I decided to double down again. There are no guarantees but preliminary results are promising.

    Why do I recommend IM?
    1. It's easy: 15 picks every 90 days. Most picks are repeated at least once, some more than eight times.
    2. It's flexible: if a pick goes bad you only hold it for 90 days.
    3. Time saving: the IM team vets hundreds of HF SEC reports every 90 days and produces a list of 15 SC picks from the best stock pickers in the world. A world-class research department for less than a dollar a day.
    4. It works. Need I say more?

    One admonishment: have faith in the model, hold all 15 picks for ninety days.
  • I want to thank you and the team for the great results this past year. Many of my friends and colleagues use profesional financial advisors and annually pay 1% to 1.5% of their portfolio value for mediocre results. Insider Monkey's performance is outstanding for a mere fraction of the cost. I am an analyst for a utility and have always wanted to invest in high growth small cap stocks, but I have never had the time, expertise or access to the information needed to effectively research them, and was never comfortable with casual stock recommendations from magazines, blogs, and television. I had never subscribed to a premium publication but was immediately impressed with the Insider Monkey team’s analysis and the proven results of the 15 Stock Small Cap Strategy.

    Keep up the great work. Thus far, the Insider Monkey team’s approach has enhanced my investment portfolio and I look forward to future issues and following the team’s investment strategy throughout the foreseeable future.
    Jim T.
    New York