Despite a reputation for their investment prowess, hedge funds have not exactly set the financial world on fire over the past five years.
The widely followed Barclay’s hedge fund index generated an average 3.36% annual gain between 2011 and 2015. That compares to 12.58% for the S&P 500.
An annual underperformance of 9.22% is nothing short of astonishing.
Some investors were unsurprised.
Back in 2008, Warren Buffett made a $1-million bet against the entire industry with hedge fund Protégé Partners.
The terms were straightforward.
Protégé Partners picked a group of hedge funds that it expected to outperform an S&P 500 index fund over the course of 10 years.
Eight years into the bet in May 2016, the fund Buffett picked — Admiral Shares Vanguard 500 Index Fund — was up 65.67%.
Protégé’s funds of funds — funds that own a portfolio of positions in a range of hedge funds — were up, on average, a mere 21.87%.
So, what explains the hedge funds’ poor showing?
First, if you are focused on managing your downside, as hedge funds are, it is hard to beat a good-old-fashioned bull market. There are times — and the last seven years is one of them — when being “dumb and long” is the single best strategy.
Second, hedge funds typically charge 2% plus an incentive, or “carry,” of 20% of the profits. The Admiral Shares fund, by contrast, charges expenses of only 0.05% a year. To deliver an equivalent return, after fees, a typical hedge fund would have had to outperform consistently by 2½ percentage points a year.
Third, to talk about an “average” hedge fund is misleading. There is a broad range of arcane hedge-fund strategies, each one looking to slice and dice the financial markets in a different way. Global macro funds bet on movements in interest rate currencies and commodities. Long-short funds buy good stocks and sell bad ones. Activist hedge funds like those run by Carl Icahn generate significant gains by pressuring companies to get their financial acts together. Different strategies yield different results.
Picking off Hedge Funds’ Best Ideas
Every major hedge fund manager must disclose the holdings in all equity assets on a quarterly basis in Form 13F.
Specifically, this requirement applies to institutional investment managers with assets under management of at least $100 million.
The Global X Guru Index ETF (GURU) uses a proprietary methodology to compile the highest conviction ideas from a select pool of hedge funds where the 13F information is most valuable. It then invests in these ideas through an exchange-traded fund (ETF).
Critics suggest that 13F data is outdated, by definition, and offers investors no edge.
I disagree. I believe that gaining access to top hedge funds’ highest conviction ideas — the product of millions of dollars of sophisticated research — without having to pay out high management fees, is of tremendous value.
With that, here are the top three current stock picks in Global X Guru Index ETF (GURU).
- Incyte Corporation (INCY)
Founded in 1991, Delaware-based biotech Incyte Corporation focuses on the discovery, development and commercialization of proprietary therapeutics in oncology in the United States and internationally.
INCY has gained more than 33.9% over the past six months. INCY is currently trading at over 76 times forward earnings, making it an expensive stock. However, baked into this price is the ever-looming prospect of being acquired by a larger biotech player like Gilead (GILD).
- Spirit AeroSystems Holdings, Inc. (SPR)
Founded in 1927, Kansas-based Spirit AeroSystems Holdings, Inc. (SPR) supplies commercial fuselage systems, propulsion systems and wing systems.
Spirit has gained over 20.7% in the past six months. Both a cheap and steady stock, it is currently trading at a forward price-to-earnings (P/E) ratio of only 11.6. The stock trades in line with the market and has a beta of .99.
- Investors Bancorp Inc. (ISBC)
Founded in 1926 and headquartered in Short Hills, New Jersey. Investors Bancorp, Inc. is a community bank with 140 offices located in New Jersey and New York.
Investors Bancorp has gained over 19.02% in the past six months and has rallied hard since the Nov. 8 election. Trading at a forward P/E of 21, the stock has a beta of .56, making it a very steady, low volatility stock in any portfolio.
P.S. Looking at top hedge fund managers’ favorite picks is one of the strategies I pursue in my monthly publication, The Alpha Investor Letter. Most recently, I recommended the top pick of hedge fund legend George Soros. According to the most recent filings, this company accounts for an eye-popping 16.52% of Soros’ investment portfolio — by far his largest position. To find out the name of this recommendation, subscribe to The Alpha Investor Letter today.
In case you missed it, I encourage you to read my e-letter column from last week about how Trump’s victory could lead the market in a positive direction.