It Doesn’t Pay to Pile Into Hedge-Fund Favorites

by Daniel Putnam | May 28, 2013 7:00 am

Each quarter, the release of hedge funds’ regulatory filings regarding their current holdings unleashes a wave of media coverage about what the “smart money” is doing. But while this makes for moderately interesting reading, the real question is whether these reports are actionable for individual investors.

If recent data is any indication, the future success of hedge funds’ largest holdings is essentially a crap shoot.

Goldman Sachs aggregates hedge funds’ holdings into what it calls its “Very Important Positions List,” or VIP List. The list is released each quarter late in the second month, and it shows hedge funds’ favorite stocks as of the previous quarter-end. As would be expected, this process skews the list in favor of mega-cap stocks. The current list, which shows holdings as of March 31, 2013, is as follows:

American International Group (AIG[1])
Google (GOOG[2])
Apple (AAPL[3])
Citigroup (C[4])
General Motors (GM[5])
[6] (PCLN[7])
Virgin Media (VMED[8])
News Corp. (NWS[9])
Microsoft (MSFT[10])
Hertz Global Holdings (HTZ[11])

While in theory it seems like buying the collective “best ideas” of the most sophisticated investors would be a good bet, this strategy wouldn’t have added much value. A look at the Goldman VIP list from the first quarter from 2010 through 2012 shows plenty of big winners, but also overall underperformance in two of the three calendar years. This table measures performance based on quarter-end data, not the date when the list becomes available to investors.

2010 VIPs 1-Year Return 2011 VIPs 1-Year Return 2012 VIPs 1-Year Return
Apple 48.3% Apple 72.0% Apple -25.1%
Bank of America -25.1% Microsoft 30.5% Google 23.9%
Google 3.5% JPMorgan 2.5% Express Scripts 6.4%
Microsoft -11.4% Google 9.3% Microsoft -8.7%
JPMorgan 3.5% Citigroup -17.2% Qualcomm -0.1%
Pfizer 23.6% Qualcomm 26.1% Citigroup 21.1%
CIT Group 9.2% LyondellBasell 29.8% General Motors 8.5%
Intel -6.6% Pfizer 16.2% Priceline -4.1%
Qualcomm 33.0% CIT Group -3.1% JPMorgan 6.3%
Cisco Systems -33.9% Chemtura -1.3% Delphi Automotive 41.0%
Average 4.1% 16.5% 6.9%
SPDR S&P 500 ETF 15.6% 8.4% 13.7%
Stocks involved in merger arbitrage trades were excluded.

There’s no doubt that this is a small sample, but it does make sense that there would be little advantage in owning the hedge-fund favorites.

First, the fact that these stocks are top holdings indicates that the funds could already be fully invested in the positions — meaning the managers might be more likely to sell than to buy more. Second, top holdings can reach that status from the impact of recent price appreciation — which can be seen just by looking at the list of 2013’s first-quarter favorites above. As a result, there’s an element of “buying high” that is built into any list of this nature.

The past two years also have brought two glaring examples of the dangers of venturing into any over-owned stock. First, of course, is Apple — the top hedge-fund holding in each of the past three years. While performance-chasing helped drive Apple to its 2012 high, it also left a dearth of buyers once the stock began to turn south. The result is that the stock today stands 36% lower than it did at its peak.

Similarly, SPDR Gold Shares (GLD[12]) — which doesn’t appear in the table above since the Goldman list only tracks individual stocks, not ETFs — was the must-own security of the first half of 2011. The ETF suffered from the same type of unwinding as Apple, and today it remains mired near a 52-week low nearly two years after its peak.

Which of 2013’s top stocks could be in danger of a similar fate?

Among this year’s top 10, Google looks to be a prime candidate. Not only is it the no. 2 holding among hedge funds, but it is also the most heavily owned among the 50 largest actively managed U.S. mutual funds. The stock’s fundamentals are sound, and it is trading at an inexpensive 16.6 times forward earnings, but its status as the stock everyone can agree on should be a red flag for the bulls.

The Bottom Line

Hedge fund activities will always be a source of media attention, especially when it comes to the holdings of giants such as Ray Dalio or Steven Cohen, but investors can’t use lists such as the Goldman VIP as a source of buying ideas.

If anything, seeing a stock you own on one of these lists argues for tightening stops in case your investment becomes the next Apple or GLD.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. AIG:
  2. GOOG:
  3. AAPL:
  4. C:
  5. GM:

  6. :
  7. PCLN:
  8. VMED:
  9. NWS:
  10. MSFT:
  11. HTZ:
  12. GLD:

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