Google defines a hedge fund as “a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.” According to Fortune Magazine, some of this year’s most volatile stocks have a key factor in common: Hedge Funds own a high percentage of their shares.
According to Hedge Fund Research, they as a group lost money in 2015 and the first quarter of 2016-their worst performance in years. To make matters worse, $15.1 Billion has marched out of Hedge Funds during the first quarter of 2016, the industry’s biggest withdrawal since the recession of 2009. Hedge Funds tend to favor investments with high earnings growth and a proclivity for acquisitions, as well as “momentum” stocks companies on an upward tear ahead of the market.
According to Bob Olstein, a value manager and the founder of the Olstein mutual fund family, “hedge funds love buying companies that are sexy but aren’t producing any cash”. Concentrating on only this type of investing can sting shareholders when sentiment about the economy sours like it did in the first quarter of this year when bear market fears spurred by China and tepid global growth took center stage.
To make matters worse, Hedge Funds have a tendency towards the herd mentality. They often crowd into the same stocks which leaves a shortage of prospective buyers when they try to flood out at the same time. This worsens the drop of the stock price they are all trying to get out of at the same time because by this point, some mutual fund managers and individual investors are also trying to head for the same exit.
Fortune ran an analysis of US companies with a market capitalization of $1 billion or more and a clear pattern emerged. Companies with lower hedge fund ownership performed better. These companies also had other characteristics in common. These companies had less debt, were larger in size, and their earnings grew at a much slower and consistent basis. They did not have the scent of instability that normally attracts the hedge funds.
Of course having said all this doesn’t mean that simply owning companies with the lowest hedge fund ownership is a promising long-term strategy. Stocks that hedge funds traditionally buy are expected to perform well again once; the U.S. and global economies show clear signs of growth, China’s slowdown stops threatening the rest of the world, and investors stop worrying so much about the potential market crash. (Good luck figuring out when all of that is going to happen.)
All in all, between the illiquidity and the high risk nature of hedge funds, we prefer to use mutual funds with proven long term track records.