Hedge funds are being shown in a relatively poor light considering their unimpressive returns this year when juxtaposed against those of the S&P500.

The latest ‘Hedge Fund Trend Monitor’ study from Amanda Sneider, David J. Kostin, Stuart Kaiser, Ben Snider, Rima Reddy and Aaron Woodside of Goldman Sachs Portfolio Research puts this in rather stark perspective:

– The typical hedge fund generated a 2013 YTD return of 6% through October 31, compared to 25% gains for both the S&P 500 and the average large-cap core mutual fund (see Exhibit 1).

– At mid-year 2013 the average hedge fund had returned 4%, suggesting second-half gains of 2% while the S&P 500 rose nearly 5%.

– The distribution of YTD performance suggests that 20% of hedge funds have generated absolute losses.

1-hedge-f-returns hedge funds

Justifying 2-and-20 is harder

Hedge funds routinely declared 20%+ returns (and never had a down year) during the decade from 1990 through 2000. They seem to have hit a speed-breaker thereafter – average returns are trending lower and three years saw negative returns.

And they’ve touched a nadir in 2013, considering what an investor could have earned by simply putting his money in an index ETF and relaxing on the beach.

“It’s easy to look at hedge funds in a straight-up environment and say, ‘Who in their right mind would pay 2 and 20 and taxes?’ But it was not that long ago, we had two big, economic events,” says Stephen Martiros, an independent investment consultant quoted in this Reuters article. “People still believe there’s a lot of systemic risk globally.” Obviously, investors have yet to get over their phobias of the 2000 recession and the 2008 financial crisis.

Strategy: ‘CC’ the hedge funds

CC = “Copy” the “Concentration.” One strategy may be to simply invest in a basket of 20 stocks that are the most concentrated in hedge fund portfolios. This is a Goldman Sachs strategy that has outperformed the market 69% of the time by an average of 261 bp per quarter.

2-most-conc-returns

Note that this strategy works selectively.

“The high hedge fund concentration strategy works in an upward trending market but tends to perform poorly during choppy or flat markets. The stocks in the basket tend to be mid-caps (at the lower end of the S&P 500 capitalization distribution), which outperformed large-caps from 2004 to 2007, contributing to the attractive back-test results,” say the Goldman Sachs strategists.

3-relative-perf-conc-baskets

It therefore appears that this is a strategy suited to the current market conditions, which are unmistakably trending higher. Here’s the latest “most concentrated” basket:

4-most-conc-stocks