Where alpha lives: Best and worst conviction bets of the year
Alpha can be won or lost by stock picking and position sizing choices. Conviction affected some large gains as well as losses in 2014.
Intro
If you follow our blog you know that we have been talking a lot about conviction bets of hedge fund managers and that real alpha still exists in the industry. But not all conviction bets turn out profitable. In fact, many go south. Just like the best managers are only right about 55% of the time, conviction bets of the entire hedge fund industry also suffer a similar fate. However, as George Soros states – it does not matter how often you are right, just how much you make when you’re right versus how much you lose when you’re wrong. Let’s take a look at 2014 and see how HF conviction bets have fared for managers last year. For this post we ran our conviction portfolio through Alpha, the Novus analytics engine and did a simple attribution analysis for 2014.
Win/loss over batting average
In 2014 there have been 43 stocks that fit our definition of “conviction” bets. Out of the 43, 25 (or 66%) made money, five were flat and 13 were detractors for the year. That equates to a 66% batting average – not bad, right? Unfortunately, not in comparison to the “consensus” bets – the portfolio of the most commonly held stocks by hedge funds had a 74% batting average for the year (similar to the S&P 500).When we dig deeper we get a glimpse at how hedge funds make money on conviction – it’s just like George Soros said. The average winning trade in conviction made 82 bps, while the average detractor cost 49 bps for a 1.7x win/loss ratio. Consensus winning bets made only 65 bps on average and the detractors cost 48 bps, a win/loss ratio of 1.35x. A strong win/loss ratio trumps a weak batting average, and in just one year conviction outperformed consensus by 5%. Managers think of this concept as watering your plants and cutting your weeds – they let their winners run and limit their losses on bad bets. Now, let’s take a look at the conviction bets that worked out last year.
The good
Despite oil’s slide in Q3 of last year and the reaction of energy related stocks, the largest winning conviction position was Cheniere Energy, Inc. (NYSE: LNG), held by 118 managers in our Hedge Fund Universe, 16 of which made it a core position (as of 9/30 filings). It’s no big surprise that we see Apple and Facebook at the top of the list as well. Alibaba rounds up the top ten, making the conviction list just a few months after its IPO. Here are the rest of the top conviction contributors:
The bad
As we said before not all conviction bets are winners. Ocwen Financial Corp (NYSE: OCN) was a poor bet in 2014 as the stock slid over 30% in the first quarter of the year. Here are the other names that cost managers:
Do you believe the win/loss ratio is a good way to evaluate your own investment process or that of your managers? Contact the author to learn more about using position data to add a new dimension to your research.