So far this year, the 30 most widely shorted stocks from the beginning of 2013- as measured by the number of shares short as a percentage of the float- have returned 34%, outperforming the S&P 500 by a considerable margin. While in our analysis these stocks do have an average beta a bit higher than 1- about 1.2, judging from daily returns this year- this isn’t high enough to account for their superior returns. In other words, so far this year heavily shorted stocks have, on average been good sources of alpha.
Take Questcor Pharmaceuticals Inc (NASDAQ:QCOR), for instance. Short sellers had sold nearly half of the stock’s float at the beginning of this year, placing the provider of drugs treating multiple sclerosis and other conditions near the top of “most popular shorts” lists. Yet the stock was up over 90% even before a pop in July after adjusted earnings per share came in well above consensus forecasts. Another example would be SUPERVALU INC. (NYSE:SVU), an owner of grocery store chains which had been heavily shorted at the beginning of this year on the basis of its poor performance. Supervalu has beaten expectations and is now up over 180% year to date.
Of course, hedge funds don’t only seem to have questionable performance in picking shorts. They also charge high management and performance fees- the standard being 2% of assets and 20% of profits (often, profits above a given hurdle rate). But on average, hedge funds still have positive returns year to date. Why is this the case? Because their long positions have done well, both due to an overall rise and the market and due to another factor- hedge funds are often very, very good at finding alpha in small cap stocks.
In fact, our research shows that the most popular small cap stocks among hedge funds, as determined by quarterly 13F filings, earn an average excess return of 18 percentage points per year. We began trading a portfolio based on these techniques last August, and over the 11 months since inception these stocks outperformed the S&P 500 by 33 percentage points. Learn more about our small cap strategy. Note that this strategy has a significant delay included in it: 13Fs aren’t released until several weeks after the end of the quarter (and disclose long positions as of the end of that quarter). We attribute hedge funds’ strong returns in small caps to the fact that they get to unleash their research teams on stocks which are generally underfollowed by large institutional investors and the financial media, and are therefore more likely to uncover hidden value.
Hedge funds have some advantages for large institutional investors who are looking for investment opportunities uncorrelated with the rest of their portfolios, but for most individual investors these funds are not a good solution. There’s good reason to doubt their shorting prowess, fees are of course high, and many of these funds’ secret sauce- their small cap picks- are publicly available within a time frame which we’ve shown doesn’t impede performance.
Disclosure: I own no shares of any stocks mentioned in this article.
