World Beta Blog

Are hedge funds the juiced up managers that deliver outsized returns to go along with their outsized fees? Or are they just mediocrity in disguise? Maybe they are former shadows of the heyday years of Tiger and Soros? Or maybe there are some great ones, and some awful ones. . .

There is very little in the academic literature regarding the use of 13F filings to delve into institutional manger long-only holdings. One teriffic working paper I have come across is written by a University of Texas professor, John Griffin, and titled, “How Smart are the Smart Guys? A Unique View from Hedge Fund Stock Holdings”

The ABSTRACT is below, but I will save you the time in reading the 61 page article(great paper however) with my summary following the abstract (bold text is my edit):

- Hedge fund assets have grown 32-fold from $38B in 1990 to $1.225T in 2006.
- 30-40% of hedge funds are L/S Equity Funds.
- He examines 306 hedge funds from 1980 to 2004 from 13F filings.
- 13Fs include positions that are greater than 10,000 shares or $200,000.
- Median hedge fund has twice the quarterly turnover of the median mutual fund.
- Compared to mutual fund weights, hedge fund weights are much less like the market portfolio.
- Relative to mutual funds, hedge funds are overweight small caps and underweight large caps.
- Hedge funds prefer medium-sized value stocks but strongly avoid the largest value stocks.
- Hedge funds are not heavy momentum players, and relative to CRSP and mutual fund weights, they have larger holdings in past loser stocks.- Hedge funds prefer stocks with low analyst coverage, less liquidity, and more volatility.
- Statistically significant, but economically weak evidence that hedge fund trading leads mutual fund trading.
- Large bets (concentrated positions) do not pay off for mutual or hedge funds (contrasting the Morgan Stanley study).- Hedge stock picking added 2.15% p.a vs only .82% for mutual funds.
- Most of this outperformance is generated in 1999 and 2000.
- No evidence of sector timing ability in hedge funds.
- Average correlation of .55 (.64 median) for long-only compared to reported returns for funds. (Exactly what we found for Greenlight, .55)

Another paper is by Rene Stulz titled, “Hedge Funds: Past, Present and Future“. In the paper he opines that “the performance gap between hedge funds and mutual funds will narrow, that regulatory developments will limit the flexibility of hedge funds, and that hedge funds will become more institutionalized.”

ABSTRACT for Smart Guys Paper

“We provide the first comprehensive examination of hedge funds’ long-equity positions and the performance of these stock holdings. Compared to mutual funds, hedge funds have higher turnover, weights further away from the market portfolio, prefer smaller opaque securities, and their trading moves slightly in front of mutual funds. However, despite their active trading nature, aggregate hedge fund trading and holdings are not beneficial in predicting the cross-section of future stock returns, indicating that on average hedge fund long-equity positions are not informed. Decomposing returns into three components, we find some weak statistical evidence on a value-weighted basis that hedge funds are better at stock picking (1.32 percent per year) than mutual funds, but this result is driven by tech stock holdings in 1999 and 2000 and becomes statistically insignificant if looking at equal-weighted performance or with price-to-sales benchmarks. The sector timing ability and average style choices of hedge funds are no better than that of mutual funds. Additionally, we fail to find differential ability between hedge funds. Overall, our study raises serious questions about the proficiency of hedge fund managers.”

S&P has a published screen that follows the Buffett methodology based on Robert Hagstrom’s book “The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor.” The criteria are as follows:

1. Owner earnings (cash flow – capital expenditures) > $50M (changed in February 2006 from $20M).
2. Net margins > 15% for the trailing 12 months.
3. ROE > 15% for previous Q and every year for the last three years.
4. Retained earnings that have grown less than the market cap, on an absolute basis, in the last 5 years.

Over the same time period, a monthly rebalance of this screen would have done ~11.4% vs. ~14% for the 13F method we mentioned in our previous article “How to REALLY trade like Warren Buffett“ . The S&P screen would have been more active, as well as more volatile. So why not just buy what Buffett is actually buying?

Let me know if you have any funds of particular interest that you would like me to take a look at. Blue Ridge, Maverick, Private, and Appaloosa are all on our (lengthy) list. . .

Joel Greenblatt recently wrote an investment book titled “The Little Book That Beats The Market.” It included a description of an investment strategy focusing on a magic formula with two inputs – high return on capital and a high earnings yield. The book is a great intro into factor based equity screening. Currently he owns four stocks – Wal Mart (WMT), American Express (AXP), Autozone (AZO), and Aeropostale (ARO). You can follow along with his holdings here.

Interestingly enough, Grennblatt’s siter runs her own hedge fund (Saddle Rock Capital) with ~ $170M AUM. Even more interesting, she only owns two stocks – Aeropostale(ARO, 2.9M shares) and Abercrombie and Fitch (ANF, 1.2M shares). Talk about some serious cajones! But then again, it was none other than Buffett himself that said, “Wide diversification is only required when investors do not understand what they are doing.”

Last summer David Einhorn won $659,730 for placing 18th in the World Series of Poker. Thats a pretty nice take for most people, but Einhorn isn’t most people. The 37-year old fund manager donated all of the proceeds to the Michael J. Fox Foundation for Parkinson’s Research. Placing 18th out of over 8,000 entrants is an amazing accomplishment, but so is beating the financial markets with a 25%+ return for the previous decade.

Einhorn started his hedge fund, Greenlight Capital, in 1995 after getting rejected from every Ph.D. program to which he applied. That $1M starting stake has since grown to over $4 billion.

In poker, it would be a huge advantage to know what cards the other players are holding. Being privy to what the best hedge funds on the Street hold would be a major advantage as well. By taking a dive into the SEC Edgar database and 13F filings, and investor can do just that.

Below we take a look at Greenlight’s holdings since 2000 via the 13F forms in a method similar to the Buffett study. The only variant is that this time we only take the top 10 holdings by size in the portfolio (to make it more manageable to track for the investor). Again, it includes all stocks that are no longer listed due to delistings, buyouts, mergers, bankruptcies, etc.

Many people would argue that I am simply taking advantage of the crystal ball effect (I know that Greenlight has done well in the past). True, but I would much rather have Einhorn picking my stocks (or Johnny Chan playing my cards) than your average mutual fund manager that can’t even beat his benchmark.

Some would also argue that the good returns are behind him, and that the size of his fund is restrictive. To that I say take a quick peek at what Citadel and SAC did in returns in 2006, both of which are > $10B in assets (Hint: Its over 30%).

(Note: We included all stocks no longer listed. While most people believe that including the stocks will increase results (takeovers, etc), in our two examples below they REDUCED results by ~400 bps. . . )

RESULTS FOR GREENLIGHT AND EMINENCE

The results were very strong, and will differ from those achieved by Greenlight for a whole host of reasons. Since this portfolio is long-only, the returns should be more volatile than his long-short fund. (One could also run this or any portfolio long with index or option hedges). Regardless, the results are below with ~30% annual returns, 30% volatility, and a Sharpe of around .95. If you then subtract the 2% management fee and 20% performance fee, you get pretty close to the 25% return reported in the general media for GL.