Mind The Bubble: Should You Be Tracking Hedge Funds?

Hedge funds have filed their 13Fs for the reporting period of March 31 and the results are in! According to research conducted by FactSet, the top 50 largest hedge funds increased their equity exposure by 5.3% in Q1 2015. Exposure to the U.S. was increased as well as exposure to the energy sector. In addition, Apple (NASDAQ:AAPL) remained the top holding and the top purchases were Valeant (NYSE:VRX) and Qualcomm (NASDAQ:QCOM). At the sector level, the aggregate hedge fund portfolio was overweight in four sectors and underweight in six sectors relative to the S&P 500 at the end of the first quarter. The Consumer Discretionary (NYSEARCA:XLY) (16.8% vs. 12.6%) and Energy (NYSEARCA:XLE) (11.4% vs. 8.0%) sectors were the most overweight sectors, while the Consumer Staples (NYSEARCA:XLP) (6.1% vs. 9.7%), Financials (NYSEARCA:XLF) (13.4% vs. 16.2%), and Information Technology (NYSEARCA:XLK) (17.4% vs. 19.7%) sectors were the most underweight sectors.

The question is: Should we care? Well as a starting point, equity hedge funds returned 1.4% in 2014, 11.1% in 2013, and 4.8% in 2012. At first blush, these results are downright embarrassing compared to the S&P 500 (NYSEARCA:SPY) which returned 13.5% in 2014, 32.3% gain in 2013, and 16% gain in 2012. Does this mean we should conclude that tracking hedge fund ownership is a waste of time?

I would argue that the answer is no. There are many brilliant money managers out there and historically hedge funds have been able to deliver more impressive alpha than mutual funds and index funds. Past performance is no guarantee of future performance, yet lets not forget that some managers like Carl Icahn and Warren Buffett have been able to average double digit compounded annual returns over the course of their investing careers.

The problem is that this kind of success has created a large demand for hedge funds causing diminishing returns for two main reasons:

1) With the proliferation of demand, funds have gotten excessively large and managers have been pressured to allocate bigger percentages of their portfolios to large-cap stocks which are typically more efficiently priced. This has led hedge funds to track the market instead of beating it. Even Warren Buffet has famously stated that his performance would be far more compelling if he simply managed less money leading certain commentators to go so far as to say that his portfolio has become a mutual fund.

2) The second problem is tied to the fact that most managers only have a handful of great ideas. Although he gives higher weight to these ideas, he still allocates to many smaller positions in order to mitigate risk, deploy more total capital and thus extract higher management fees. This portfolio allocation ends up having a profound effect on total alpha generation.

Finally, there is one other issue inherent in the financial industry itself that investors should be weary of when tracking hedge fund ownership. In a recent Bloomberg article the author outlined the findings of a fascinating note released by Citigroup. In this note it was suggested that the financial industry, by its very nature, “is doomed to forever be blowing bubbles.” Why? Because the performance of an asset manager is often judged against a benchmark which doesn’t necessarily have much relevance to their particular investment approach. If the manager believes a particular type of asset, asset class, or even industry is overvalued he may be pressured into holding it because his supposed benchmark does. If he chooses not to, his investors may head for the exits in light of possible underperformance. This is what the Citi analysts had to say:

“A weary client once defined a bubble to us: “something I get fired for not owning”. It is career-threatening for an asset manager to fight a big bubble. For example, the late 1990s [technology, media and communications] bubble almost destroyed the value-based fund management community. Any bond manager hoping that valuations were mean-reverting would have been fired many years ago.
Big bubbles are especially dangerous. TMT stocks already represented a large part of equity market benchmarks when they re-rated aggressively in the late 1990s. By contrast, Biotech stocks might currently be expensive but their small market cap means they are still not a big benchmark risk. You don’t get fired for not owning Biotech stocks now, but you did get fired for not owning TMT stocks in the late 1990s.
Bubbles are obvious in hindsight, but they are very hard to fight in real time. Indeed, proper bubbles are so overwhelming that they force sceptical fund managers to buy into them in order to reduce benchmark risk and avoid significant asset outflows. As these sceptics capitulate, of course they contribute to the bubble and so force other sceptics to capitulate and so on and on until there are no sceptics left to capitulate. It makes sense for an asset management company to manage its business risk but this can end up contributing to the madness. Through this, the modern fund management is almost hard-wired to produce bubbles.”

Nevertheless, tracking hedge fund ownership can be useful in order to train your mind to spot trends and find new stock ideas. The trick is to be able to separate the great ideas from the mediocre ones and spot bubbles before you join the crowd inside one.