By Meena Krishnamsetty
Hedge funds are much better investors than you are made to believe by the financial press. Even hedge fund indices hide the truth about hedge funds' amazing talent in picking winners and losers. I am going to present convincing evidence of this.
However, my advice to you is to dump your hedge funds.
The fact is that most hedge fund investors don't make as much money as they did in the 90s and the first half of the past decade, where alpha in excess of 10% was the norm. Aggregately speaking, hedge funds' alpha has been in decline over the past decade for several reasons. They are as follows:
1) A greater level of competition within the hedge fund industry has caused profit margins to shrink.
2) Hedge funds got bigger and started investing in less profitable areas.
3) There are a lot of unskilled hedge fund managers who are trying to get rich by being "lucky."
4) Equity hedge funds charge an arm and a leg for beta exposure.
However, before getting into the details about why you should dump your hedge funds, I want to set the record straight on one issue that has been bothering me for a very long time.
You may have read maybe a few hundred articles where the author compares hedge funds' returns with the returns of the S&P 500 index. This is a flawed premise. Equity hedge funds aren't 100% long, so it really doesn't make sense to compare their performance to the broader market indices.
The reason is simple. Hedge funds are, well, hedged.
Now, they aren't usually 100% hedged, but their market exposure is 50% on the average, and this fluctuates from year to year as their managers attempt to time market fluctuations. In order to have a better understanding of hedge funds' long-only performance, Insider Monkey created a 30-stock portfolio of the most popular stocks among fund managers. Between 1999 and 2009, this 30-stock portfolio outperformed the market by 11 basis points per month, and its monthly alpha was 19 basis points (read the details here).
At the beginning of this year, we created the "Billionaire Hedge Fund Index," which tracks 30 of the most popular stocks among billionaires (and it is 100% long). Recently, we partnered with MarketWatch and co-branded this index as the MarketWatch/Insider Monkey Billionaire Hedge Fund Index. In 2012, this index has returned 24.3% vs. 16.0% for the S&P 500 ETF (NYSEARCA:SPY). That's an outperformance of 8.3 percentage points.
On the other hand, according to HFR, long/short equity hedge funds have returned only 6% last year. Isn't it obvious that you will be grossly misled if you compare 6% with SPY's 16% return?
It should be clear to you, then, that hedge funds' large-cap stock picks are marginally better than the S&P 500 index. However, if you are a hedge fund client, you won't see much outperformance in this space because you have to surrender 2% of your assets and 20% of this year's return to your hedge fund manager. If he or she was a closet indexer this year, their fund's gross return would have been 16% on the long side of their portfolio, but net returns would have less than 11%.
On the bright side, many academic studies show that the average hedge fund still generates enough alpha to neutralize the effect of high fees.
Still, my advice to you is to dump your hedge funds.
Hedge funds can't generate enough alpha in the large-cap space to justify their high fees. They invest in the large caps because they have too much money to manage, and they don't want to give up juicy management fees that enable them buy condos on New York City's Park Avenue. How do hedge fund managers "get away with murder" (i.e., murder of their clients' assets)?
The answer is simple.
They generate significantly higher alpha in their small-cap stock investments. Generally speaking, there are fewer analysts covering the little guys, and these stocks are less efficiently priced. Hedge funds spend enormous resources to analyze and uncover 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.
Between 1999 and 2009, the 15 most popular small-cap stocks among hedge funds managed to beat the market by 1.4 percentage points per month.
That is not a typo. Reread it.
This outperformance wasn't due to high risk, either. Our small-cap strategy's monthly alpha was 1.2% per month during this 10-year period (read the details here). This isn't even the end of the story.
We launched a newsletter at the end of August that lists the stock picks of this small-cap strategy. Our stock picks returned 14.3% vs. 2.1% return for the S&P 500 ETF since we first published our list four months ago.
Our proposition is very simple: dump your hedge funds and imitate their small-cap stock picks. United Rentals (NYSE:URI) has been the most popular small-cap stock among hedge funds since the end of second quarter. We also brought United Rentals to your attention on Marketwatch last June. The stock returned 45% since the end of June. Here is what we wrote about the stock in the first issue of our newsletter at the end of August:
"United Rentals rents equipment such as construction, industrial, and earthmoving equipment as well as lighter pieces such as generators and heaters. Wall Street analysts currently expect strong earnings growth from the stock -- consensus expectations for this quarter are $1.14 in earnings (up from 92 cents in Q3 2011) and for the fourth quarter the number is 99 cents (up from 82 cents). For 2013 analysts expect $4.67 in earnings per share; assuming the company meets this trajectory, it trades at seven times forward earnings."
When we wrote this paragraph, the stock was trading below $32 (current price is $48). Currently, analysts project EPS of $4.79 for 2013. This is an increase of 40% compared to 2012, yet the stock's forward PE ratio is only 10. It isn't too late to buy the stock despite the 50% increase since we made it our top pick at the end of August. Stocks with single digit earnings growth trade at 13-16 times their expected earnings. United Rentals deserves a similar multiple. The stock has been our strategy's top pick for the past 4.5 months, and it will stay that way till at least the middle of February (see the other 14 stocks picked by our strategy in our newsletter).
Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.