Stock pickers fail to shine in downturn

It is easy to look smart when the equity market is soaring. The time when stock pickers really shine is when markets take a turn for the worse — or so they claim.

The quarter just ended was certainly a turn for the worse, a 7 per cent slide by the US S&P 500 and its weakest performance since 2011, so did the world’s biggest and best remunerated hedge fund managers pick the best stocks for weathering the downturn? The evidence suggests not.

Of the 10 stocks most heavily owned by the largest hedge funds at the end of the second quarter, only two were up at the end of the third, and both of those by less than 1 per cent. Their biggest holding, Apple, which was in the portfolios of 26 of the 50 largest hedge funds, according to FactSet, lost 12 per cent of its value in three months.

Worse was Valeant Pharmaceuticals, which was the second most heavily owned stock at the start of the quarter, accounting for 1.5 per cent of the value of the long positions of the 50 funds — almost as much as Apple. Valeant’s backers include industry stars John Paulson and Bill Ackman. Its shares plunged 20 per cent on the political backlash against high drug prices. Allergan, another popular healthcare stock, was down 10 per cent.

Worst of all was Williams Companies, a favourite of activist managers and another of the top 10 hedge fund holdings, which fell 36 per cent. Even its planned merger with fellow gas pipelines group Energy Transfer Equity could not offset the gloom enveloping the energy infrastructure sector.

Go further down the list of hedge fund-owned stocks and the picture gets no better. The top 50 most popular stocks at the end of the second quarter, as revealed by the funds’ 13F regulatory filings, averaged a decline of 8.4 per cent in the third.

To be fair, hedge funds are more than the sum of their equity holdings. By definition, they are able to hedge, placing offsetting negative bets that should mean their actual performance is much better than the average of the long positions shown in their 13F filings.

It is also true that the 13Fs show only a snapshot at the end of the quarter, one that is already stale when they are published. Maybe we will discover that many managers were smart enough to sell out of Apple, Valeant, Williams et al before their shares tanked.

The indications are that the difference between the best and worst managers was wider than usual in the third quarter. The market has been particularly treacherous not just because of fears over Chinese growth, but because of computer-driven trading that has increased volatility. Timing one’s trades correctly has been decisive. Already some big losers are known: David Einhorn’s Greenlight Capital is down about 17 per cent year to date; Mr Ackman is down 13 per cent.

Funds of a more bearish bent, such as Passport Capital, are up strongly. How these performances average out for the industry as a whole remains to be seen.

One of the more bizarre investment phenomena of recent years is the creation of mutual funds that purport to track or “clone” hedge fund performance based on 13F filings. Individual investors, too, scour the filings for ideas. Yet the perceived undervaluation that attracted a hedge fund into a stock at some point in the preceding three months may be long gone by the time their holding becomes public.

Meanwhile, there is precious little evidence that their picks subsequently outperform. The third-quarter performance of stocks that appeared most often in the second-quarter 13F filings was disappointing but not atypical. The average performance of the top 50 most popular shares was worse than that of the S&P 500 in three of the past four quarters, according to FactSet.

It is sometimes claimed that stocks widely owned by hedge funds are more prone to volatility, either because hedge funds leverage their positions or because they are more short term in their trading. That might make the stocks overshoot on the way up and underperform when the market turns down. But the FactSet data cover two “up” quarters and two “down” quarters.

The truth might therefore be more prosaic: hedge fund stock picks do not do significantly better or worse than the market on average. That argues against rushing to invest based on 13F filings, for sure. It also rather raises the question of whether their stock picking prowess justifies their “two and 20” fees.

stephen.foley@ft.com