Following the Hedgies Pays Off, Part 1

 | Jan 07, 2013 | 1:30 PM EST  | Comments
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At Insider Monkey, we're big believers of imitating the smart money. Over at Institutional Investor's Alpha, Stephen Taub published an article titled "Beware the Temptation to Follow Hedge Funds' 13F Filings." We respectfully disagree with his analysis.

You can beat the market following hedge funds' 13F filings, and we'll show you how.

Why should you mimic hedge funds' stock picks? To address this question, we'll critique Taub's article, which gathers some of the most popular arguments against this strategy.

Taub's first argument: Hedge funds' most popular stocks performed terribly since September. This means that it's not always a good idea to mimic their top picks.

Counter: You can always find a time period where any investment strategy underperforms.

It's no secret that some of tech's biggest names have been struggling over the past few months. You'd have to be living under a rock to miss the daily news of Apple's (AAPL) fall from the $700 mark. But let's be clear: Any investor who owned Apple, Google (GOOG) and Microsoft (MSFT) for the entirety of 2012 would have come out in the green. Apple returned more than 30%, Google was up 9.5%, and Microsoft gained 2.9%.

Our main point, though, is that in order to test any investment strategy, an actual empirical analysis must be done, and the time period must be much longer than simply three months. We did one, and the results speak for themselves.

We have 10 years of 13F data for 92% of all hedge funds between 1999 and 2009. The 30 most popular picks among hedge funds generated a positive alpha of 10 basis points per month. This means that on a risk-adjusted basis, hedge funds' most popular stock picks outperformed the market by around 1 percentage point per year over the 10 years we analyzed.

Taub's second argument: There is a 45-day delay in reporting, and hedge funds' portfolios might change significantly. He assumes that you cannot beat the market because of this delay. He also assumes that you cannot replicate hedge funds because of this delay.

Counter: This delay actually helps investors' ability to beat the market by imitating hedge funds.

It's easy to assume that hedge funds are great at timing the market, but in fact, this isn't always the case. If funds are early into an investment, then imitating them after a 45-day delay might yield even better results. We can prove that this is the case.

In our original analysis, we also used a two-month delay in our back-test of hedge funds' 30 most popular picks. We found that between 1999 and 2009, these most popular stocks generated a monthly alpha of 19 basis points (more than 2 percentage points per year). In short, our results got even better.

Taub's third argument: Hedge funds use exception rules and hide some of their positions for a certain period of time, sometimes even longer than 45 days. He assumes that this delay makes these stock picks worthless.

Counter: We used all filings (including from funds that disclose positions several months late) and found positive alpha -- a degree of return that comes from the stock's inherent value rather than from market volatility.

The assertion is incorrect that exception rules somehow prevent some of hedge funds' stock picks from being discovered until it's too late. Our analysis shows that even with this longer delay, it's still possible for 13F mimickers to generate a positive alpha.

Taub's conclusion: Don't treat 13F filings as a valuable tool that will enable you to invest like the smart money.

Counter: By looking at the actual data, our research shows that imitating hedge funds' most popular stock picks generated a monthly alpha of 19 basis points. But that's not the whole story.

Investors who imitate hedge funds' most popular small-cap stock picks increase their chances of beating the market significantly. On the whole, hedge funds generate significantly higher alpha in the small-cap space. Fewer analysts cover the little guys, and these stocks are less efficiently priced.

We recently started sharing our best strategies in our quarterly newsletter. Since going online in August, our small-cap strategy has beaten the SPDR S&P 500 (SPY) by 12.2 percentage points over the past four months.

While our track record is shorter than most, our bevy of back-tests prove that this strategy works. 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. 

In Part 2 of this column, we'll name five stocks that hedge funds love.

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