Where Alpha Lives: Conviction Crushes Consensus by Stan Altshuller, Novus
Too good to be true?
What if I told you there was a hedge fund that almost doubled the returns of the market over the last decade and did so with the same volatility? Here are the stats since 2004:
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Furthermore, what if I said that this fund has no fees, has full transparency and daily liquidity? You’d probably say that it’s too good to be true. In fact, what I am describing is not a fund at all, it’s just a collection of 20 stocks, refreshed quarterly based on our public data scrubbing and what we call our “Conviction” strategy. It’s really a way to take advantage of hedge fund stock picking and position sizing – two very important skills managers rely on to generate their returns. Thanks to Uncle Sam it is possible to aggregate public ownership data across a large number of managers and isolate just the stocks that hedge funds express conviction in. Our prior research explains the mechanics of the strategy. You might point out that there is a lag for these filings and you’d be right – you need to wait 45 days after the reporting period to put on your trades. However due to the low turnover of the strategy the lag has a minimal impact. That impact is just around 100 bps a year for a strategy accounting for a 45 day lag post filings and allowing for one day to put on the trades. That is a lot less than what an investor can expect to pay in fees for managers trading in real time.
Conviction generates steady out-performance
It turns out, conviction does remarkably well even in stressed markets. Take a look at the draw down profile comparison of the 20 stocks versus the 500 in the S&P index over the last decade. (Why is this an apt comparison?)
The total value of the drawdown and its length are smaller for conviction stocks. We can only hypothesize on the reason for such a limited down side. We think that managers know these 20 conviction stocks extremely well and hang on to them like a life raft in rough waters. They are convinced the stocks will rebound. And they sure do. This is evidenced by great up-capture and down-capture ratios; the numbers show that these stocks capture a lot more of the upside moves than the down moves of the markets.
How about shorts?
We track a few different strategies based on public ownership data. One that surprised us was the consensus strategy. It simply consists of the 20 most popular stocks of hedge funds, regardless of position size. Surprisingly, this portfolio consistently under-performs. We think that managers have little conviction in these popular stocks and put them in their portfolios for other reasons. They are dumped at first sign of trouble. This makes the strategy a good short candidate and some investors might be able to construct a market neutral portfolio isolating the Alpha inherent in conviction.
In today’s low rate environment many of our clients are looking for alternative means for achieving higher returns and some turn to our data to construct similar strategies to tap into hedge fund skills and bypass the fees. There are also some ETFs available that do similar ownership-based tracking like AlphaClone’s ALFA, iBillionaire’s IBLN and Global X GURU.
Our clients use our data to construct their own tracking strategies. Do you think you can benefit from access to hedge fund conviction? Contact us to learn how.