In this article we will share the details of a quantitative investment strategy that outperformed the market by more than 27 percentage points annually between 2015 and 2017. Investors, public, and the media are obsessed with mega-cap stocks like Apple, Microsoft, Facebook, and Google. Our research has shown that an equally weighted portfolio composed of hedge funds’ 30 most popular picks generated a monthly alpha of 8 basis points between 1999 and 2016. This 30-stock portfolio also underperformed the market by 5 basis points per month though. On the other hand hedge funds’ top 30 mid-cap stock picks outperformed the market by 28 basis points per month between 1999 and 2016. Investors could have beaten the market by more than 3 percentage points per year by focusing on the slightly smaller stocks.
It isn’t a secret that the markets are more efficient when it comes to pricing mega-cap stocks. Hundreds of analysts already look into these stocks, so there isn’t much to uncover that can yield significantly higher abnormal returns. Hedge funds know this but they are managing too much money, so they have no other option (other than returning money back to their clients and giving up lucrative fees) but to invest in these mega-cap stocks.
This isn’t the case when it comes to small-cap stocks. There aren’t a lot of analysts and investors tracking small cap stocks and these stocks are less efficiently priced. Hedge funds spend enormous resources on analyzing and uncovering data about these stocks because this is one of the places where they can generate significant outperformance. Our analysis also shows that this is a fertile ground for piggyback investors.
We have been sharing the stock picks of our small-cap hedge fund strategy since the end of August 2012. Through March 11th, 2015 our small-cap strategy returned 132.0%. S&P 500 ETF (SPY) returned only 52.6% during the same period. Our small-cap hedge fund strategy outperformed the market by 79.4 percentage points over this 2.5 year period.
Unfortunately, our small-cap strategy stopped working in the summer of 2015 and it gave back all of the excess returns generated in the first 2.5 years.
We conducted a thorough investigation of why this strategy stopped working. We found out that there was a huge increase in the number of equity hedge funds in recent years and many of these new breed of hedge fund managers were simply imitating the trades of other hedge fund managers without doing any meaningful analysis. So, when David Einhorn pitched SunEdison as a investment idea in his investor letters and at hedge fund conferences, dozens of fund managers blindly followed Einhorn into SunEdison and made it the most popular small-cap stocks among ALL hedge funds. In another corner of the hedge fund world though there is another group of hedge fund managers who actually conducted in-depth analyses of SunEdison, reached a different conclusion and sold the stock.
SunEdison went bankrupt. There were several other stocks like SunEdison where the stock was extremely popular among one group of hedge fund managers and another group of hedge fund managers were forcefully shorting the stock. In some cases bullish hedge fund managers were right, but in majority of the cases bearish fund managers were right and these stocks underperformed the market by a large margin.
We went back and calculated the returns of these “battleground” small-cap stocks in our small-cap strategy’s portfolio. These stocks returned 41.6% between the end of August 2012 and February 15th, 2017, whereas S&P 500 ETF (SPY) returned 82.7% during the same period.
These stocks have been a major source of underperformance. We learned from this horrible experience that we should be paying attention to the consensus stocks of only the best performing hedge fund managers and we should be shorting the battleground stocks as a hedge.
Since its inception in May 2014 through December 3, 2018, our best performing hedge funds strategy returned 78.4%, vs. 60.4% for the S&P 500 ETF (SPY) (read the details of this strategy here). We started tracking the real-time returns of the battleground short stocks on February 15th, 2017. These stocks lost 24% since then, vs. 22.8% gain for SPY during the same period.
We have been receiving several questions on a daily basis from our readers, so we decided to share the results of our historical analysis of the battleground short stocks. Unfortunately, our strategy can’t be perfectly replicated using historical data. Our strategy excludes a large number of the hedge funds. For example, our strategy was using only 394 hedge funds’ stock picks at the end of August 2012 when we launched our newsletter. There were 799 hedge funds in the historical 13F dataset we are using for research. We can’t go back in time and pick and choose among hedge funds without introducing some sort of bias toward successful/unsuccessful hedge funds. So, in this analysis we will use the stock picks of ALL hedge funds. This won’t be a 100% accurate representation of our methodology but we’d rather err on the side of being conservative.
We ranked stocks with market caps between $1 billion and $5 billion by counting the number of hedge funds with long stock positions in each stock. We picked the battleground short stocks from the list of the top 15 stocks at the end of each quarter. These stocks returned an average of 0.09% between 2006 and 2017, whereas the S&P 500 Total Return Index had an average monthly gain of 0.79% basis points during the same 12 year period. Battleground short stocks also underperformed the market by more than 27 percentage points annually between 2015 and 2017.
Here are the annual returns of our back test:
| Year | Battleground Short Stocks (Back Test) | S&P 500 Total Return |
|---|---|---|
| 2006 | 0.0% | 15.8% |
| 2007 | -24.3% | 5.5% |
| 2008 | -59.6% | -37.0% |
| 2009 | 81.9% | 26.5% |
| 2010 | -13.1% | 15.1% |
| 2011 | -13.4% | 2.1% |
| 2012 | 40.7% | 16.0% |
| 2013 | 41.2% | 32.4% |
| 2014 | 26.9 | 13.7% |
| 2015 | -20.5% | 1.4% |
| 2016 | -21.0% | 12% |
| 2017 | -5.2% | 21.8% |
We believe investors can benefit greatly by ignoring the large-cap stocks and focusing on hedge funds’ small-cap picks. Hedge funds reveal their best ideas in their 13F filings. By sorting through the noise and identifying the best stock picks of the best hedge fund managers, investors can achieve outstanding results. Investors also generate superior returns by hedging their long exposure by shorting the battleground stocks. We share hedge funds’ best and worst ideas in our quarterly newsletter. You can download a free issue by signing up.