The Most Important Stocks in Hedge Funds: Consensus Index

Don’t you love it when a pre-conceived notion is proven wrong by hard evidence, like when Galileo proved that the earth revolves around the sun and not vice-versa? We do, and that’s what makes us true data nerds at Novus: we let the data tell the story, and throw away old opinions if they conflict with conclusive evidence. We found something fascinating while analyzing Public Ownership Data on hedge funds, and while it might not have the same magnitude of implications as disproving the geocentric model, it is still interesting enough to inform you, the smart investor. Are you ready?

The most popular stocks bought by hedge funds underperform the market.

Yep, that’s it. And if you don’t think that’s exciting enough, keep reading, it gets better. We thought we were building a good pool for long stock ideas for our clients when constructing our Novus Consensus Index from our database of public disclosures by global hedge funds. Turns out, not so much. Don’t worry, we’ve been wrong before. We also constructed an index tracking the most crowded stocks in hedge funds while looking for a good short basket candidate. We love being wrong, especially when our clients benefit.

Performance

If you gathered the stock picks of every hedge fund that files a 13F and put them all together in one group, you’d have something close to what we call our Hedge Fund Universe. It’s a market-value weighted portfolio of over 1,000 hedge fund managers compiled from regulatory filings over the years. Next, if you were to construct a portfolio of the most common stocks among the group, you would create something like our Consensus Index. And if you were to buy those consensus stocks, you would underperform miserably.

Accounting for the lag associated with filings, the Consensus Index returned a paltry 5.2% annualized compared to the 8.2% you would get from the S&P 500 since 2004. But don’t feel bad. Hedge funds actually fared even worse! Without the 45 day lag the portfolio returned 5% flat. Take a look at the persistence of this underperformance to S&P 500 with dividends:

Looking at all the 12-month periods, you would be hard-pressed to find any time the index outperforms the market. Also, it exhibits sharper drawdowns in stressed environments. Far from a long candidate, we think this could be a good short.

Sectors

The alpha generated by sectors in the Consensus index has been abysmal. Since the inception of the index, May 2004 through last month, hedge funds lost money by picking the wrong stocks in almost every sector. Security selection is the contribution from picking stocks that outperform their sector benchmarks, in other words, stock picking alpha. A rare sight in hedge funds (or any active management) is negative stock selection contributed across the board – when the average stock in every sector underperforms its sector benchmark. But that exactly is what we get from consensus. IT is the single stand out, but the number is so low, basically flat, you might as well have held an IT ETF.

Why is This Happening?

The short answer is I’m not sure. It’s not due to any trivial reason like a sector or a market cap tilt. Both exhibit typical hedge fund characteristics, very similar to our conviction index that outperforms markets consistently, and by a wide margin. Heavy on IT, Health Care and Financials, light on Materials and Industrials. One exception is Consumer Discretionary; a normal hedge fund overweight is light in consensus.

My best guess for the underperformance is that it has to do with position sizing and lack of conviction in some popular hedge fund names. Conviction stocks represent mostly large bets for hedge funds, consensus does not have such restrictions. The index contains popular names that are sometimes very small parts of manager portfolios. There is less conviction in these stocks, less research that goes into buying them, and thus they are lower quality investments. Whatever the reason, if you believe in data, you should not buy stocks simply because they are popular among hedge funds. While this might not be as momentous as discovering planetary movement and might not even earn me the label of heretic from hedge fund managers, it’s something that every investor who follows hedge funds should know. Simply following the crowd doesn’t pay, even a very smart crowd.

When Investing in a Specialist Makes Sense

Investing in hedge funds shouldn’t be rocket science, but there are countless nuances when choosing managers: hundreds of funds running dozens of strategies, charging high fees, and sure enough, half of them are below average. In this complex environment, even the simplest of decisions can be difficult.

One question our clients often ask is whether they should invest in a specialist or generalist, and when it makes sense. In our latest report, we take a hard look at the data to discover when it makes sense to invest in a sector specialist, and which sector specialists outperform.