How to Identify Top Hedge Fund Managers Using Public Ownership Data by Stan Altshuller, Novus
If you’re searching for the best money managers, are you only concerned with how they performed in the past, or would you like to predict how they will perform on your dime? A manager’s future performance is going to depend on a few different factors, with the markets they are playing in being one definitive driver. Sheer luck is also going to be a factor. Another critical factor will be the investment skills they bring to the table as an active manager. Investing in managers with skill will improve your odds of a successful outcome. Yet, looking at past returns alone, it’s difficult to figure out the portion directly attributable to skill. More and more investors are using data beyond returns to screen for managers based on skill, precisely the skill they can rely on for future performance.
How to Identify Top Hedge Fund Managers Using Public Ownership Data
Ownership data refers to positions disclosed by managers adhering to reporting regulations around the world. Using this ownership data it is possible to tease out skill sets by stringing historical filings together and linking them to simulate portfolio returns. When you do this, the data tells a rich story – it tells you how the manager achieved returns, not just how much was made.
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How to Identify Skill
Once you know what to look for, skill sets are not hard to identify. We are going to focus on three skill sets (out of many) that managers rely on to generate returns: Security selection, position sizing and the win/loss ratio. The reason we focus on these three is that they are fairly simple to calculate using ownership data. To isolate these skills we need to simulate historical portfolio performance based on reported holdings for each manager in our universe. Once this is done we can isolate the portion of the manager’s return attributable to each skill. Now we will briefly touch on the three skill sets we are looking for and provide examples of some managers that consistently come up as winners on our skill-based screens.
“Once you know what to look for, skill sets are not hard to identify.”
Security Selection Skill
Security Selection Skill refers to a manager’s ability to choose the top performing stocks within a certain group of securities (such as a sector or market cap) that outperform that group as a whole. To estimate this skill in managers using public ownership data, we need to control for the manager’s exposure to a portion of the market they participate in,
such as a sector specific benchmark. For instance, to understand security selection in the healthcare sector, we can ask the following question: Do US healthcare securities that the manager chose to invest in outperform the S&P1500 Healthcare index consistently? To find top stock pickers in each sector, we filter for managers with meaningful total exposure to the sector, the number of securities the manager historically invested in the sector and how long the manager has been investing in the sector. We do this to make sure only managers with significant presence in each sector are considered. We then run screens on managers that consistently demonstrate security selection skill.
One example of a manager that shows up on the lists for top stock pickers in multiple sectors is Locust Wood Capital Management. Looking at just the portion of their returns attributable to security selection for each sector, it’s clear that their stocks outperform the benchmarks, especially in Financials. This is fortunate because that also happens to be their largest sector allocation at 35% of their public portfolio.
In fact, the manager has added value above the benchmarks in most sectors they participate in. Their security selection skill for the past five years has been positive across the board save Health Care, which is only a 5% allocation in their book. Very few managers can make such a claim. If this manager wants to make the case for being an excellent stock picker, the numbers are on their side.
Position Sizing Skill
Position Sizing is perhaps the most important skill a portfolio manager can possess. A manager holding all the securities in a passive benchmark can over- or underperform significantly just based on sizing decisions. This skill speaks to the conviction of the manager in their best ideas and an inherent understanding of relative value and risk control. Thankfully, estimating this skill set is straight forward from public ownership data. We can compare the performance of the actual weighted portfolio to an equally weighted portfolio – the delta between the two is attributable mostly to sizing decisions. One of the most skilled managers based on position sizing skill is Coatue Capital whose simulated returns trounced the equally weighted portfolio returns since 2000. In the last five years this skill is striking in a comparison of their simulated portfolio based on their actual weights and a portfolio with the same stocks all equally weighted. It is clear that this manager has consistently benefited from a deep understanding of how to size positions relative to each other.
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