In this article we explain what hedge funds are, how they work, why fund managers fail to beat the market or index funds (with some exceptions), and how you, as a private investor, can use information on these funds to pick their best stocks.
We also explain how you can find out which stocks the big hedge fund managers invest in. In other words, which companies they buy and what trades they make.
What are hedge funds?
Hedge funds can take different legal forms, such as investment funds or companies. Either way, they are still collective investment vehicles made up of hundreds or thousands of investors who deposit their money for the fund to manage.
Unlike index funds, these funds are actively managed and usually take long or short positions in shares, and they can use all kinds of derivatives and leverage. This is perhaps the most eye-catching part for the investors who put their money into hedge funds: unlike other funds that track an index, these funds can earn higher returns in a bear market, because their managers can bet against the market or against a particular listed company.
All of this is in theory, because in practice very few hedge funds manage to beat the return of an index fund.
Hedge funds charge a fixed fee plus a variable one that depends on the fund’s return and the alpha achieved. And there are precisely two concepts we need to grasp to understand hedge funds: beta and alpha.
What is the beta of a hedge fund or investment fund?
The beta of an investment fund (and also of hedge funds and other investment vehicles) measures whether a fund is more or less volatile than its benchmark asset or index.
See also: Why Warren Buffett doesn’t invest in tech companies but does invest in Coca-Cola
In other words, if you are investing in an equity fund benchmarked to the S&P 500 or the Ibex 35, the fund’s beta measures how the fund behaves relative to that index.
For example:
If the beta is 1, the fund behaves in the same way as its benchmark index. That is, if the Ibex rises 3%, the fund returns 3%. Index funds have a beta of 1 because they replicate the behaviour of their benchmark index.
If the fund’s beta is greater than 1, the fund is more volatile than the market. It carries more risk, but also more return. In this case, if the index rises 3%, the fund could rise 8% or 10%. If the index falls 3%, the fund could fall 8% or 10%. A beta greater than 1 means the investment fund makes wider moves than the market. This also tends to happen with leveraged derivatives. They always have a beta above 1.
If the fund’s beta is below 1, it basically means the fund is less volatile than its benchmark index. If the index falls, the fund falls less. But of course, if the index rises, the fund’s return will also be lower.
What is the alpha of a hedge fund?
A fund’s alpha is the extra return a fund manager manages to achieve over the benchmark index.
In other words, if the benchmark index has risen 5% and the fund has risen 8%, that 3% of extra return is due to the fund’s alpha, and it is considered to have been achieved thanks to the fund manager’s work.
If a hedge fund has a positive alpha, it means the manager has had good investment ideas that earned more for the fund’s investors, which is why the manager collects a variable fee on the extra return.
If, on the other hand, the fund has had a negative alpha, it means the manager has added no value with their investment ideas and has in fact done worse than an index fund or passively managed fund. In that case, the hedge fund would only charge its investors the fixed part of its fees.
Why don’t fund managers beat their benchmarks or an index fund?
Let’s be realistic. A hedge fund charges investors higher fees because it is actively managed and, supposedly, because that active management will earn higher returns than an index fund, which charges very low fees. That is the theory, because in practice we can see that, on average, funds do not beat the return of the indices over the long term.
See also: Beware of forecasts when investing in the stock market
If the market falls 30%, an average hedge fund will probably fall between 15% and 20% because of the market drop. If the market rises 30%, an average hedge fund will rise between 13% and 18%. We can see that an average hedge fund underperforms the index in a bull market and outperforms it in a bear market. This is mainly because, in bear markets, the hedge fund can open short positions. Even so, over the long term it does not beat the return of an index fund (with some exceptions).
Does this mean active fund managers are fools when it comes to picking stocks?
Not exactly. There are a few things you should know about hedge funds.
We need to bear in mind what makes up a hedge fund’s return, which, as we explained earlier, would be:
- The return driven by beta exposure.
- The abnormal return generated by the hedge fund manager’s skill (alpha).
- Management and performance fees (more alpha = more return = more fees).
The average alpha of the average hedge fund fell below zero from 2005 onwards. This means that if, as an investor, you had put 50% of your investment capital into an index fund and the other 50% into Treasury bills, you would have earned a higher return than the average hedge fund investor.
Why have hedge funds had negative alpha over the last decade?
Although there is no clear answer to this, we can draw several conclusions from observation.
We can see that hedge funds’ long positions in US shares are concentrated in large-cap companies as they attract more capital from new investors. You could say that hedge fund managers have reduced their alpha in order to lower their risk.
The large-cap companies in fund portfolios have been beating the market by less than 2 percentage points a year before fees. The problem for investors is that a hedge fund charges, on average, 2% in management fees and another 2% in performance fees.
The managers already know they cannot generate enough alpha by investing in large-cap shares, but it is a way of being able to say they have been doing well, to justify charging management and performance fees, even though the investor’s return is practically the same as, or lower than, if they had invested in an index fund.
But as we were saying, fund managers are not as foolish as they seem if we only look at the surface in terms of returns.
How to benefit from hedge funds without investing in them
A hedge fund is not just one thinking head; it is made up of several advisers who specialise in different areas. If the fund invests in large-cap companies even though it knows it will not generate enough alpha, one of the reasons is that it moves many billions that it cannot risk on the other investment ideas we are about to see.
We can see that hedge funds have beaten the market by a wide margin if we remove the large-cap shares and focus only on small-cap companies.
In other words, the 20 most popular small-cap stocks among hedge funds have beaten the indices by almost 20 percentage points a year. The problem is that most of the investment capital goes into large-cap companies, while small caps make up a very small share of hedge funds’ investments, so they do not contribute significantly to raising the fund’s alpha.
So, as private investors, all we should do is analyse which small-cap investment ideas are popular among hedge funds, choose 5, 10 or 20 of them and invest there on our own.
And this is not rocket science, although identifying these companies takes a lot of work and patience.
How can you find out which companies hedge funds invest in?
If you want to know which companies a hedge fund is investing in, in Spain there is Fondium.com, which gives information on our investment funds and roughly which companies they are investing in.
But to see which shares the top-flight managers invest in, there is Whalewisdom.com, which publishes the investment portfolios of the biggest hedge fund managers.
What you do need to bear in mind is that we cannot know where a fund has invested until the following three months.
See also: The fascinating life and career of Bill Ackman, hedge fund manager
Featured image: Apostolos, CC BY-SA 2.0, via Wikimedia Commons.
