Equity hedge funds returned 1.4% in 2014, 11.1% in 2013, and 4.8% in 2012. These are embarrassingly low compared to the S&P 500 ETF (SPY)s 13.5% gain in 2014, 32.3% gain in 2013, and 16% gain in 2012. Does this mean that hedge fund managers are dumb as a rock when it comes to picking stocks?

The answer is definitely no. Our small-cap hedge fund strategy which identifies the best stock picks of the best hedge fund managers returned 28.2% in 2014, 53.2% in 2013, and 33.3% in 2012 (see the details as well as back test results here ). So why is there such a huge difference between actual hedge fund returns and the performance of their best ideas?

Lets explain:

1. Historically hedge funds delivered high alpha, especially when compared to the mutual funds and index funds. This success attracted more and more funds from investors who didn’t want to be left out. As hedge funds assets began to swell, they started to invest in “ideas” that they’re less comfortable with. Returns in a hedge fund’s 35th best idea wont usually return as much as the hedge fund’s top ten ideas. They also allocated a higher percentage of their portfolio to larger-cap stocks which are relatively more efficiently priced. So it isn’t surprising that hedge funds’ alpha has been on a declining trajectory for the last decade. Some of most recent studies even claim that the average hedge fund today doesn’t have any alpha.

2. This should be alarming for hedge fund investors. Hedge funds are becoming like mutual funds. Not generating any alpha doesn’t mean that hedge fund managers are losing their stock picking abilities. One reason for that is the adverse selection problem. People with no stock picking ability have enormous incentives to launch hedge funds. If they get lucky, they’ll make millions. If they don’t get lucky, the investors will lose and not them. Bottomline is that not all hedge fund managers are talented. Investors need to avoid pretenders.

3. The third reason is that hedge fund managers pocket between 30% and 80% of their total returns. The residual returns after fees and expenses are what investors get and these are the returns that researchers say have no alpha anymore. Hedge funds still generate positive alpha before management fees.

So why do we track hedge funds? Because we want to find out the best stock picks of the best hedge fund managers and dont pay them a dime. The returns of our small-cap hedge fund strategy supports our thesis that it is possible to identify the best stock picks of the best hedge fund managers and we dont have to pay them a dime for these publicly available stock picks.

A typical manager has a small number of good ideas. Hell give higher weight to these ideas in his portfolio. The remaining positions are usually large in number but smaller in weight. These positions help fund managers to diversify, deploy more capital, and extract higher management fees. Investors shouldnt invest in these mediocre ideas; they reduce average returns. Investors should avoid mediocre fund managers; they have no skill in picking stocks. Finally, investors shouldnt pay 30-80% of their profits as fees to turn hedge fund managers into billionaires. Read the details of our small-cap strategy that seems to be successful in achieving these goals.

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