A (deep) contrarian view: Buy the basket of top holdings in US Hedge Funds

by Angel Sanz



Source: Bloomberg

2016 has been a very tough year for active managers, especially in the equity US market (both hedge funds and long only funds). From 31-Dec-15 to 30-April-16, the SP500 NTR has gained 1.73% whereas the Tremont Long-Short Index has dropped 4.52%. Several reasons may explain this:

• Metals and oil prices “unexpectedly” rebounded very quickly and the basic resources companies outperformed dramatically the market. Hedge fund managers were underexposed or short these sectors.
• World economic growth data disappointed again, long-term rates dropped and as a consequence the low volatility interest rate sensitive sectors (consumer staples, utilities, telco services) also outperformed. Hedge fund managers were underexposed or short these sectors.
• Momentum factor has not performed this year, and hedge funds are typically momentum oriented.

On a quarterly basis, Goldman Sachs update a list with the 50 stocks that most frequently appear among the largest 10 holdings of hedge funds. This list is called GSTHHVIP, from now on, the BASKET. In the graph above you can see the relative performance of the BASKET versus the S&P500 Net Total Return. This has been the second worst period for the BASKET (relative to the index) for the last 10 years with a relative underperformance of 11.5% during the last 11 months.


The “unexpected” sector rotation that took place during the first 5 months of the year has started to revert and fundamentals are becoming (again) more important than technical factors.
Typical low growth or very cyclical companies are starting to underperform whereas more stable or growth companies like information technology or health care have started to outperform.
Correlation between stocks and correlation between sectors have decreased to lower levels, typical symptoms of a “more rational” market.
Hedge funds, though expensive sometimes, are still the most talented people in the industry and after periods of underperformance they tend to recover (See chart).
From the sector point of view the basket is overweighting Consumer Discretionary and Health Care companies which is in line with our market view.
From the technical point of view, the MACD signal (indicates changes in a security’s underlying price trend, so you can identify turning points) is giving a very strong indication to buy the BASKET index relative to the SP500


Buy the BASKET and short the SP500. This trade has a historical volatility of about 6%, so it can be implemented with 2 times leverage. Historically, the beta of this basket has been 0.13.
Time horizon for this trade: In the past, it took between 3 months to 9 months to grasp the profits of this trade.
Why do not make a trade long the HF top holdings and short the HF less owned stocks? Because the least owned stocks have outperformed the market in the past (surprise, surprise!)
Why do not make a trade similar to this with the overweight positions of the mutual fund industry? Because the data is only 4 years old and the relative performance has historically be less important.

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