Go Where Hedge Funds Fear to Tread

 | Dec 08, 2011 | 2:00 PM EST
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After changing a flat in the rain on my way home from seeing the third-grade Christmas pageant last night, I spent some time on the phone discussing the news of the day. The key topics were where Albert Pujols would sign and what actions, if any, the Europeans would take to save the world economy.

Most folks I spoke with hoped King Albert would stay in Saint Louis (he didn't). As for Europe, anything short of default and restructuring is just another form of can-kicking and doesn't really solve the region's problems. Pushing liquidity and low interest rates is not going to do it, either. And it doesn't appear to me that the various governments will ever agree on a real policy to fix the Europe's problems. I find myself in agreement with billionaire hedge funder Marc Lasry of Avenue Capital, who says buy Northern Europe and visit Southern Europe.

The conversations eventually turned to the subject of hedge funds. We discussed various hedge fund indices and were a little surprised by how badly most of the funds were performing in 2011. The whole idea of paying the traditional "Two and Twenty" hedge fund fee (2% of assets managed and 20% of profits) is to find a vehicle to prosper with during volatile times. The big boys' club of global macro managers was supposed to be the best at this, but for the year, as an asset class, they are down between 5% and 10%. Event-driven funds and activist investors are down more than 10% as a whole, according to various tracking indices. Even the merger arbitrage crowd is struggling to stay above water, even as a lack of deals and reduced leverage dampen returns.

One explanation for the lack of performance is the continuing trend of converging correlation. Gold, stocks, bonds, oil and just about everything else are responding to the same news. Years ago, news that drove stocks up would drive gold down. If bonds were off big, that was bad for stocks and good for oil. There were trading and investing relationships that made a certain amount of economic sense.

Today, most of those tried-and-true market relationships no longer hold true.

Also, everyone owns the same stuff. Be they macro, value or growth in nature, just about everyone came into the year long gold and gold stocks. Many managers paired that trade with being short Treasury bonds, figuring something had to give. It would be harder to find someone who wasn't long Apple (AAPL) or Microsoft (MSFT) in 2011 than to identify the hedge-fund managers who own those stocks. A thousand institutions own shares of Citigroup (C), and half of them bought more last quarter. More than a thousand own Bank of America (BAC) and, again, more than half were buyers last quarter.

But these crowded trades and positions create an opportunity for the little guy. By the time these trades and stock picks hit the headlines, it's time to avoid the situation. Instead, we can look for ideas that the large funds and institutions can't. For instance, if you like the idea of being long bank stocks rather than owning what all the big hedge funds own, why not buy Fox Chase Bancorp (FXCB)? This small bank has a better balance sheet and less political risk than the bigger banks. Fewer than 75 institutions own FXCB shares and the hedge funds that have a position in the stock are long-term buy-and-hold types, as opposed to larger, hot-money funds. You own better stocks with less volatility just by avoiding the over-owned issues held by the largest hedge funds.

I track several of the value, distressed and activist investors to steal ideas from time to time. However, in my search I look for the gems that are not already owned by a couple of hundred of their peers. I have found over the years that stocks with heavy hedge fund ownership tend to have somewhat distorted valuations and are subject to price distortions related to the fund's trading activities rather than corporate developments.

I get interested in stocks heavily owned by hedge funds only when I see a massive margin call across the hedge fund landscape. We last saw this in late 2008 and into 2009, when forced selling created incredible bargains. I still have the Disney (DIS) shares I bought for $16 apiece as a result of margin-call selling by the funds. This type of event usually happens every four of five years and, when it does, it's worth having a list of top hedge-fund stocks to take advantage of extreme bargains. Most of the time, however, the list of hedge-fund stocks is a better source for short ideas than long-term-buying opportunities.

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