Hedge funds have a two-fold reputation – a good year can put you well ahead of the market, but hedge funds can also have truly frightening drawdowns. By creating a series of strategic indices that track global hedge fund performance against the market, Novus Research Chief Research Officer Stan Altshuller and research associate Yuanjie Zhang have found that highly concentrated portfolios are the cause of both high alpha and high volatility, but that looking at ‘conviction’ instead of concentration can keep most of the benefits while making the painful drawdowns less likely.

“The typical hedge fund has on average 58% of its long-equity assets invested in its top 10 positions compared with only 17% for the iShares S&P 1500 Index Fund (ETF) (NYSEARCA:ITOT),” they write. “To some extent, higher concentrations explain more volatile performance against the benchmark. Nonetheless, with solid security selection, hedge funds have generated and accumulated sizable alpha over the years.”

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Conviction is less volatile than concentration

An index composed of high concentration stocks, those with the highest percentage of shares outstanding among hedge funds, has brought in nearly double the returns of the S&P 1500 since 2004, but someone who had invested in this strategy would have taken an outsized hit during the crisis. Since the end of 2008, when cumulative alpha had fallen back near zero, this index has roared back leaving the S&P 1500 in its tracks.

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But a slightly different take on concentration gives investors a lot more stability while still beating the market. Conviction counts the number of managers who have a given stock as at least 5% of his or her portfolio (which is considered to be an investment with conviction), and creating an index with the stocks that have the highest number of managers participating with ‘conviction’ beat the market by 130% since 2004 with a much softer downturn in the wake of the crisis.

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Watch out for agreeable hedge fund managers

Hedge fund managers are supposed to be the smartest guys on the Street, and they build their reputation on their stock picking acumen, so it might not be surprising that the most commonly owned stocks underperformed. This index doesn’t take into account the size of any one position, just the number of managers who have any position with a given company. These tend to be mega caps (Apple Inc. (NASDAQ:AAPL), Google Inc (NADAQ:GOOG), and Microsoft Corporation (NASDAQ:MSFT) take top billing and every company in the top 20 is a household name), and the consensus index has underperformed the S&P 1500 by about 55% since 2004.

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