Hedge funds appear to be a secretive world and, to some degree, they are. Only high net worth individuals who meet the requirements defined by the Securities and Exchange Commission (SEC) and large institutions have access to these investments. Some funds set minimum investments of $25 million or more which limits the pool of potential investors even more.
If you can get into a fund, there is no guarantee you will make money. Some funds are very successful but, as a group, hedge funds tend to deliver average or even below average returns. One reason for the poor performance could be the high fees the funds charge. A typical hedge fund might charge investors “2 and 20” which indicates investors pay an annual fee of 2% and allow the manager to keep 20% of profits above a benchmark. Some funds charge even more with one fund, Renaissance Technologies, rumored to charge “5 and 44” or annual fees of 5% and 44% of profits.
The hedge fund world is so secretive we can’t confirm the fees of many funds. The funds aren’t required to publish a prospectus for individual investors or an annual report that discloses all expenses. They are, however, required to tell us what stocks they are buying and selling every three months.
Through these publicly available filings, some of the world’s most successful investors share the results of their research. We don’t know the specifics of their investment decision process but we do see the results of the process in these disclosures and that provides us with an opportunity to benefit from the research those steep fees pay for.
Among the filings large investors must make is SEC Form 13F, more formally called the Information Required of Institutional Investment Managers Form. 13Fs must be filed once a quarter by any investment manager with at least $100 million in assets under management. By law, 13Fs must be filed with the SEC within 45 days of the end of a quarter. For example, forms must be filed by February 15 for the quarter which ends December 31 each year.
By itself, the 13F filing can be confusing. An extract of Renaissance Technologies’ recent filing is shown below:
In order to be useful, the information from the 13F needs to be collected and analyzed in some way. When the information is moved into a sortable database, we can determine what the filer is buying and selling. We can even combine the filings to see which stocks are favored by hedge fund managers as a group. This information can be used to develop a trading strategy that follows the funds, but without the steep fees.
As a group, hedge funds tend to underperform the market. But the fifty largest funds are successful in the long run, a fact proven by the large amount of assets they control. Smaller funds are often struggling to deliver performance so they can earn rich fees but the established funds are generally proven top performers which is why they control billions of dollars.
In February, the funds were required to file 13fs telling us what their positions were on December 31. Large funds usually move in and out of positions slowly and their holdings take time to change. This indicates the data from December 31, while it may seem out of date, is actually still relevant to the current market.
From their filings, we know that the 50 largest hedge funds decreased their equity exposure by a small amount (1%) in the fourth quarter of 2016. This indicates they seemed to be taking profits as stocks rallied. The funds were prepared for the rally. Earlier filings showed they increased their exposure to stocks by 2.9% in the third quarter of 2016, ahead of the election.
That is an interesting point to consider. While experts were warning that a market sell off was likely to unfold after the election, hedge funds were buying. As experts were again warning the market was overvalued and overbought at the end of last year, funds were decreasing their exposure by only a small amount indicating they expected the rally to continue.
As a group, the fifty largest hedge funds have been right about the direction of the market trend over the past few months.
In addition to determining whether they are bullish or bearish on the broad market, the 13fs also allow us to see which sectors the hedge funds like and dislike. In the fourth quarter, the Financials and Health Care sectors received the largest investments from the funds. On the opposite end, the Consumer Staples and Information Technology groups saw the largest amount of selling among all of the sectors. The chart below shows the funds added $3.5 billion to their investments in the financial sector while selling more than $8.4 billion worth of consumer staple stocks.
Digging deeper, we can see which individual stocks were the most actively traded. That information is summarized in the next chart.
When it comes to individual stocks, selling doesn’t necessarily indicate the hedge funds expect to see a decline in those stocks. Hedge fund managers are seeking to outperform the market since that is where the performance fees come from and that is where they earn the bulk of their money.
Specifically, selling Procter & Gamble (NYSE: PG) doesn’t mean they believe that stock will decline. It simply means they expect other stocks to deliver better performance.
They may also be selling because a run up in price increased the percentage weighting of a stock in their portfolio and the stock now exceeds the allocation guidelines explained in their investment policy statement.
Because there are multiple reasons a fund could be selling, this data is interesting but not as important as the names of the stocks they are buying. In this case, we see the funds were aggressively buying NXP Semiconductors N.V. (Nasdaq: NXPI). This is a stock that has already had a significant run up in price as the long term chart shows.
Based on technical analysis, the chart pattern provides a price target of about $125, indicating there is potentially more up side ahead of this stock. Fundamentals confirm the bullish outlook.
Analysts expect NXPI to report earnings per share (EPS) of $7.29 next year, an increase of more than 14% from this year’s expected earnings. In the future, they expect EPS growth to average 16.2% a year. For growth stocks, we can use the PEG ratio to obtain a price target. The PEG ratio defines a stock as fairly valued when the price-to-earnings (P/E) ratio is equal to the EPS growth rate. For NXPI, a P/E ratio of 16.2 provides a price target of about $118, close to the target obtained with technical analysis.
Of course, the stock may not reach these targets. Qualcomm has agreed to buy the company for $110 a share. That deal is expected to close by the end of 2017 and offers a minimum return of more than 5% if the deal closes as completed/
Hedge fund managers are after performance and they may change their minds quickly. A bad earnings report could be all it takes to make some of the managers sell a position. But, the largest funds have historically been right more often than wrong otherwise investors would not entrust them with billions of dollars. This means the buys of the largest funds are worth considering.
NXPI has already had a large gain but large hedge fund managers believe additional gains are likely in the future. The same is true of their other recent buys, all of which deserve consideration as potential buy candidates.