Does Imitating Hedge Funds Make Investing Sense?

Hedge fund managers are the smartest in the business. So following their investments should net you significant returns, right? Not during the second quarter, when even the smart money got whipsawed by the market’s volatility.

Motorola Solutions CEO Greg Brown Celebrates Split Of Parent Company At NYSE

Greg Brown, president and chief executive officer of Motorola Solutions Inc., second from right, rings the closing bell at the New York Stock Exchange in New York, U.S., on Tuesday, Jan. 4, 2011. Motorola Solutions Inc., formerly Motorola Inc., today completed the previously announced separation of Motorola Mobility Inc. and began trading on the New York Stock Exchange under the ticker symbol “MSI.” Photographer: Michael Nagle/Bloomberg *** Local Caption *** Greg Brown

Michael Nagle/Bloomberg

Click here to view our slideshow

Buying the favorite stocks of hedge fund managers was not a lucrative strategy during the third quarter. Remember: around mid-August — 45 days after the second quarter ended — holders of at least $100 million in U.S. equity-oriented investments were required to tell regulators their holdings at June 30, 2011, in a 13F filing with the Securities and Exchange Commission. It is a snapshot of one day in time.

Many investors like to track these filings and then buy the top holdings of the highly rated hedge funds once these holdings are disclosed, in this case around August 16. This strategy sometimes works well. Not this time.

After the 13F documents were filed, Credit Suisse Securities Quantitative team calculated the 15 stocks most overweight by hedge funds, a list we published at the time.

Looking back, if on August 16 you bought the 15 stocks most over-weighted by hedge funds at the end of the second quarter after these holdings were disclosed in the 13F filings, you would have lost 8.53 percent. This was also worse than the S&P 500, which dropped about 5.14 percent.

And even if you were privy to these holdings when the second quarter actually ended, you still would have lost 17.33 percent. This compares with a 14.3 percent decline for the S&P 500.


The performance of the portfolio of 15 stocks, however, was skewed fairly heavily by the collapse in the shares of the web-based movie rental Netflix, which gave up more than half its value during both timeframes after the company made its very unpopular announcement in early July it would change its pricing policy.

In addition, Citigroup dropped more than 38 percent during the three-month period from July 1 through September 30.

Altogether, 11 of the 15 stocks lost money from August 16 through September 30. And although 10 of those 11 lost more than the S&P 500, only six of the 11 lost more than the 15 as a group, on average.

If you knew to buy these top holdings on July 1 — right after the second quarter ended — and held them through September 30, 13 of the 15 stocks lost money. In addition, nine of the 13 stocks that lost money fared worse than the S&P 500, especially Citigroup, which dropped more than 38 percent. Netflix fell nearly 57 percent in the third quarter.

AutoZone, a long-time favorite of ESL Partners’ Eddie Lampert, and Cephalon were the only two stocks to go up since both June 30 and August 16. However, Cephalon has been more of an arbitrage stock since its May 2 agreement to be acquired by Teva Pharmaceutical Industries for $81.50 per share. The transaction is expected to be completed in October.

Interestingly, you would have lost money with Motorola Solutions and Wellpoint if you bought them at the end of the second quarter but you would have made money since mid-August. In fact, Wellpoint was the best performer since the 13Fs were filed with the SEC, climbing more than 5 percent.

The strategy of following the hedge fund managers after the first quarter 13F filings were made public was much more lucrative.

The average return for the most widely held hedge fund stocks from the day the holdings were disclosed on May 16 through the end of that quarter was 1.8 percent. This compared to a loss of 0.7 percent for the S&P 500. If you bought the same stocks at the end of the first quarter and held them for the next three months, the average return for the group of stocks worked out to a 0.9 percent gain compared to a 0.4 percent loss for the S&P 500.

The moral of this exercise: Sometimes the smart money is in fact smart, and sometimes they too get whipsawed by the market’s volatility.

So bear that all in mind while you peruse the third quarter’s list of the 15 most overweight stocks and their performance.