The New Investment Strategy Turbocharging Hedge Funds’ Returns

It has been a tough time to be a hedge-fund manager over the past decade.

Hedge funds have lagged the S&P 500 substantially since 2006. The HFRI Index, a broad measure of hedge-fund performance, returned just 3.4% per annum since 2006. That’s 3% behind the S&P 500’s annual performance.

So what’s the source of this underperformance? I think it comes down to information.

You have more information in your pocket on your smartphone than top hedge funds did 15 years ago.

With $3 trillion of hedge-fund assets chasing opportunities, much of hedge funds’ informational “edge” has just disappeared. Strategies that worked yesterday are competed away with blinding quickness. Once identified, these strategies cede their secrets to computer algorithms that wring out every last bit of profit from financial markets.

This underperformance has put hedge funds in a bind. How can they justify charging exorbitant costs if they fail to show investors the money?

Even some of the hedge-fund industry’s founding fathers like Paul Tudor Jones have been forced to reduce their fees.

Private Equity: a New ‘Edge’

Private equity is a close cousin of hedge funds.

Private-equity investors will often buy an entire company, invest vast amounts of time and money turn it around and then sell it or list it on a stock exchange.

Unlike hedge funds, private-equity investors have made money consistently over the past decade.

No wonder some hedge funds are joining the private-equity party. Instead of making small speculative bets on stocks, a handful of hedge funds are placing big bets on private-equity-style transactions to boost their flagging returns.

Hedge funds provide the funds to finance company buyouts.

Private equity investors then do the hard work of slashing and burning companies to wring out profits.

The financial cousins share in the gains.

The Case of Bill Ackman and Pershing Square

Take the example of noted hedge-fund manager Bill Ackman and his hedge fund, Pershing Square.

Ackman’s investment philosophy is to invest only in high-quality companies.

Much like Warren Buffett, Ackman looks for simple, predictable and free-cash-flow-generative businesses with substantial barriers to entry and strong pricing power due to brands, unique assets, long-term contracts and a dominant market position.

Yet, once hailed a “Baby Buffett,” Pershing Square has had a tough time in recent years.

That is because Ackman has waged a spectacular, if mostly unsuccessful, activist campaign against Herbalife (HLF), charging that it is a pyramid scheme. Pershing Square is also a big holder of the now-disgraced biotech stock Valeant Pharmaceuticals (VRX). Ackman’s big bet on this fallen angel has backfired so far, crushing Pershing Square’s returns in the past two years.

A Publicly Traded Private-Equity Play

While Bill Ackman grabs headlines with the shenanigans surrounding Herbalife and Valeant, he has placed a much larger, if lower-profile, bet on Restaurant Brands International (QSR).

Canada-based Restaurant Brands International Inc. (QSR) is the third-largest operator of fast food restaurants in the world. Tim Hortons provides soups, sandwiches, donuts, coffee and tea restaurant services. Burger King operates fast food hamburger restaurants. Last week, the company also acquired Popeye’s Louisiana Kitchen for $1.8 billion.

According to Pershing Square’s most recent Form 13F filed with the Securities and Exchange Commission (SEC), Restaurant Brands International Inc. (QSR) is by far Ackman’s #1 position at Pershing Square. Ackman’s position in the stock today is worth $1.87 billion, an eye-popping 31.56% of Pershing Square’s portfolio.

A bet that size for a hedge fund borders on irresponsible. Yet, there are good reasons Ackman is willing to take that risk.

Restaurant Brands International is majority-owned by the Brazilian private equity giant 3G Capital. 3G Capital recently made headlines for coordinating a massive, but failed, $143 billion bid by Kraft Heinz Company (NASDAQ: KHC) for Anglo-Dutch food giant Unilever.

As a controlling shareholder, 3G Capital’s objective is to wring out greater financial efficiency from Burger King and Tim Hortons, the two major companies under the Restaurant Brands International umbrella.

Analysts call 3G Capital’s approach to restructuring its portfolio companies “the 3G way.” This method combines extreme transparency, merit-based pay, austere budgeting, promotion of young talent quickly and a spirit of competitiveness.

3G also works on the concept of “zero-based budgeting,” where every expense must be newly justified every year.

No wonder 3G Capital has become known for its cutthroat management style. As one analyst put it, 3Gs top executives are “not known for their gentle demeanor.”

Sure enough, Restaurant Brands International’s successive quarters of robust and improving earnings suggest that Burger King is closing the decade-long revenue gap with its peers Wendy’s (WEN) and McDonald’s (MCD). Tim Hortons has also begun to expand its international footprint.

While 3G is slashing and burning, Pershing Square’s investors are reaping the rewards as well. As the chart below confirms, Ackman’s big bet on Restaurant Brands International has served him well.

QSR vs S&P 500 over one year

Nor is Ackman alone in investing in “publicly traded private equity” deals.

Even pure “global macro” speculators like George Soros are betting big on private equity style-run public companies. A whopping 20.2% of George Soros’ publicly disclosed portfolio is in just such a stock.

In a world of diminishing hedge fund returns, private equity-style investments may be the world’s top hedge funds’ single best secret weapon.

Finally, betting big on stocks like Restaurant Brands International (QSR) is becoming an established trend among the “smart money” of the hedge fund world. Restaurant Brands International is also a current recommendation in my brand new monthly newsletter Smart Money Masters.

In Smart Money Masters, I make recommendations based on the latest and best “smart money” strategies. The current portfolio includes both Warren Buffett’s and George Soros’ top investment bet, as well as those of lesser-known, but potentially even more successful, hedge fund investors. Click this link to find out more.