Today's Market: Stock Picker's Delight

by: AlphaClone
By Maz Jadallah

If there is one overriding theme this year for investors, it is uncertainty. Unsure about the staying power of the recovery in the US and debt woes both here and in Europe, investors have flocked to emerging markets and have been well rewarded. The iShares emerging markets index ETF is up 12% on the year, nearly double the return in the S&P500. For investors who took a more selective approach, the returns were even better. The iShares South Africa and Korea ETFs are up 25% and 15% respectively year-to-date.

With an uneven recovery that has been neither global nor broad, 2010 has been a year where being selective and being right has really paid off – this market is a stock picker's delight. Since we base our research on the investment moves of the best stock pickers in the world, it is instructive to look under the covers of one of our core strategies to see just how being selective has paid off.

For those of you familiar with our international core investment approach, you know it invests quarterly in the ten ADR stocks that appear most often amongst the largest 20 holdings across our hedge fund universe. The strategy's backtest has returned 25.1% so far this year vs. 1.6% for the BNY ADR index (as of 10/15/2010). The results are even more impressive on a risk-adjusted basis - the YTD maximum drawdown for the strategy has been -5.2% vs. -17.1% for its benchmark. Not bad! But to what can you attribute that performance? Let's take a closer look.

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Since 1/1/2010 the strategy has held 24 unique securities (see table), of which 16, or 67%, have delivered positive returns over their respective holding periods. That's a good “win percent” but what really jumps out is how concentrated the portfolio's gains are in its best performing holding. Nearly two thirds of the total gains in the portfolio YTD are due to holding one stock, BIDU.

How many investors would have bought BIDU on 1/1/2010 AND made it their second largest weighted position? BIDU was (and is) the poster child for overhyped Chinese internet stocks! Sitting in front of your trading screens on 1/1/2010, you would have seen that the stock had gained 200% during 2009. Who would have had the nerves to bet big that the stock would return another 100% in 2010 in a shaky macro environment? Yet, at least in this specific case, that's exactly what our strategy did..

The dynamic above is not surprising to those of you experienced with the nature of returns for long/short fundamentals-focused hedge funds. The world's best stock pickers rely on “winning big” rather than “winning often”. Appaloosa returned over 120% net (the fund's top 10 holding clone was up 118% gross) in 2009 largely because they got the bank trade correct. Paulson got the gold trade correct. Perry got sub prime right. Hedge funds that do very well over a given period will have bet BIG on one or two ideas that turn out to be correct.

Ironically, while the strategy's YTD win percent is impressive, its largest weighted holding has underperformed this year returning -4.6% thus far. Despite its recent performance, Teva Pharmaceutical has consistently been the most widely held "top 20 ADR" in our hedge fund universe and it is probably a good bet the stock will carryover into the next rebalance period on November 19. With a beta of 0.18, the stock is not exactly volatile which might explain why this core strategy has a much lower maximum drawdown than its benchmark index this year.