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The Predictive Power of Information Ratios

The Predictive Power of Information Ratios

Our earlier work showed that simple performance metrics, such as nominal returns and Sharpe Ratios, revert. Because of this reversion, above-average past performers tend to become below-average and vice versa. This reversion is primarily due to systematic (factor) noise. Consequently, metrics that remove factor effects from performance reveal persistent stock picking skill. Prompted by readers’ qu[…]
The Predictive Power of Sharpe Ratios

The Predictive Power of Sharpe Ratios

Our earlier work showed that performance metrics dominated by market noise, such as simple nominal returns, revert. Because of this reversion, above-average performers of the past tend to become below-average performers and vice versa. Since the reversion is primarily due to systematic (factor) noise, metrics that control for factor exposures reveal persistent stock picking skill. Prompted by read[…]
Berkshire Hathaway’s Alpha Decay

Berkshire Hathaway’s Alpha Decay

Berkshire’s Recent Exposure and Performance Raise Questions
There is a good reason many investors consider Berkshire Hathaway the paragon of investment success. For over 20 years, Berkshire’s equity portfolio has outperformed the general market on a risk-adjusted basis. But, in the past two years Berkshire’s alpha has turned negative. We identify the principal culprit and provide evidence of styl[…]
Tests of Equity Market Hedging: U.S. Hedge Funds

Tests of Equity Market Hedging: U.S. Hedge Funds

Our earlier piece tested several equity market hedging techniques on U.S. equity mutual fund portfolios. We now extend the tests to U.S. hedge fund long equity portfolios. Since these are generally less diversified and more active than mutual funds, simplistic approaches that use a fixed 100% short (1 beta) or rely on returns-based style analysis (RBSA) fail even more dramatically for hedge funds.[…]
Tests of Equity Market Hedging: U.S. Mutual Funds

Tests of Equity Market Hedging: U.S. Mutual Funds

Equity market hedging techniques can be complex and their effectiveness hard to assess. In this piece we evaluate the effectiveness of several market hedging techniques by comparing them to the (idealized and unattainable) perfect market hedge. Specifically, we compare realized market correlations of hedged U.S. equity mutual fund portfolios to market correlations of random return series. Random r[…]
The Persistence of Negative Investment Performance

The Persistence of Negative Investment Performance

And why Poor Nominal Returns are a Reason to Hire Rather than Fire a Manager
Our earlier pieces discussed how nominal investment performance reverts. Since returns are dominated by systematic risk factors (primarily the Market), they are subject to reversal when investment regimes change. In the simplest terms, high risk funds do well in bull markets, and low risk funds do well in bear markets, i[…]
The Decay of Stock Picking Skill

The Decay of Stock Picking Skill

Our earlier work showed that nominal returns and related simplistic performance metrics are dominated by market noise and hence revert. The reversion means that yesterday’s best-performing managers tend to be tomorrow’s worst. Yet, once distilled from systematic noise, stock picking skill is evident. This piece measures the decay of stock picking performance over time and identifies the historical[…]
Top Stock Pickers’ Exposure to Valeant

Top Stock Pickers’ Exposure to Valeant

In Early – Out Just in Time
Our recent article established that a portfolio of skilled stock pickers’ ideas generates consistent alpha.  This brief analyzes what the AlphaBetaWorks Expert Aggregate had to say about one controversial name, Valeant Pharmaceuticals (VRX).  In short, the smart money was in early and left almost a year before Valeant’s recent headaches.
Performance of the Top U.S. St[…]
Testing Equity Risk Models: REIT Portfolios

Testing Equity Risk Models: REIT Portfolios

Equity risk models can be complex and hard to interpret. Moreover, differences in financial reporting and transparency across markets, sectors, and companies can lead to inaccurate predictions and counter-intuitive exposures for common fundamental models. These problems are especially severe for sector-focused portfolios. For instance, generic fundamental models may use a single broad Leverage Fac[…]
Systematic Hedge Fund Volatility

Systematic Hedge Fund Volatility

Hedge fund replication, tracking, and analysis often focus on the individual positions and on the stock-specific risk they contribute. This overlooks the far more important return source – systematic hedge fund volatility. A statistical equity risk model that robustly captures exposures to the key systematic risk factors delivers 0.92 (92%) correlation between predicted and actual returns for most[…]
Do Equity Risk Models Need a Quality Factor?

Do Equity Risk Models Need a Quality Factor?

It is common to augment risk models with numerous interrelated factors. This causes problems: Size, Value, Quality, Volatility, and their kin have much in common. At best, overzealous addition of related factors leads to unnecessarily bloated models. At worst, it leads to overfitting, multicollinearity, and questionable statistical analysis.

Fortunately, most complex factors derive virtually al[…]

Testing Equity Risk Models: Property and Casualty Insurance Portfolios

Testing Equity Risk Models: Property and Casualty Insurance Portfolios

Equity risk models can be complex and hard to interpret. Moreover, differences in financial reporting and transparency across markets and companies can lead to inaccurate prediction for common fundamental models. Yet, when properly constructed, statistical equity risk models that capture the most salient factors built on robust statistics are highly predictive. This is especially true for US Prope[…]
Testing Global Equity Risk Models

Testing Global Equity Risk Models

Due to differences in financial reporting and transparency across international markets, fundamental company data is often unsuitable for building global risk models. Consequently, global equity risk models can be even more complex, brittle, and hard to interpret than their U.S. counterparts. Global statistical equity risk models are immune to these deficiencies in fundamental data and, when prope[…]
Testing Predictions of Equity Risk Models

Testing Predictions of Equity Risk Models

Equity risk models can be complex and hard to interpret. Yet, when properly constructed, robust statistical equity risk models capturing just the most salient factors are highly predictive. For instance, Market and Sector/Industry factors alone deliver 0.96 median correlation between predictions of equity risk models and reported portfolio returns for U.S. Equity Mutual Funds.
Predictive Power of[…]
Hedge Fund Industrials Factor Timing

Hedge Fund Industrials Factor Timing

In an earlier post, we discussed the largest bets hedge fund long portfolios were making in Q1 2015. The third largest was on the Industrials Factor. This is the risk specific to the industrials sector after controlling for market exposure. It captures capital allocation to industrials and sensitivity (beta) to the sector. There is weak statistical evidence of poor industrials factor timing by hed[…]
Hedge Fund Oil Factor Timing

Hedge Fund Oil Factor Timing

In an earlier post, we discussed the largest bets hedge fund long portfolios were making in Q1 2015. The second largest was on the oil price. This exposure is the residual oil price risk after controlling for market and sector exposures. It captures overweighting within various sectors of companies that out- or underperform under rising oil price. There is weak statistical evidence of skilled oil […]
Hedge Fund U.S. Market Timing

Hedge Fund U.S. Market Timing

The single largest bet hedge fund long portfolios were making in Q1 2015 was on the U.S. market (high beta). While the bet is exceptionally large, it is not predictive of market direction. Allocators should pay attention to this risk aggregation.

At the end of Q1 2015, high market factor exposure (high beta) was the primary source of U.S. hedge funds’ long portfolio crowding. HF Aggregate, a po[…]

Top Energy Hedge Funds’ Trades

Top Energy Hedge Funds’ Trades

Energy investments have struggled in recent months. Crowded hedge fund energy bets have done especially poorly. In this piece, we explore the overall hedge fund energy performance and the results of the top stock pickers in the Oil and Gas Production, Integrated Oil, and Oilfield Services Sectors.
Top Energy Hedge Funds
Risk-adjusted return from security selection isolates managers’ stock pickin[…]
Hedge Fund Crowding Toll: January 2015

Hedge Fund Crowding Toll: January 2015

Several of our articles discussed the vulnerability of crowded hedge fund positions to volatility, mass liquidation, and losses. We illustrated specific blow-ups (SanDisk (SNDK) and eHealth (EHTH)), as well as sectors with persistently poor hedge fund performance (Oil and Gas Production and Miscellaneous Mining). However, we have not showed how representative these examples are. This piece illustr[…]
Hedge Fund Crowding Costs – eHealth

Hedge Fund Crowding Costs – eHealth

EHTH (eHealth, Inc.), an Internet health insurance agency, was down over 50% following disappointing revenue and EPS guidance. The events were yet another example of the mass sell-offs in crowded hedge fund bets after disappointing news. This once again demonstrates that investors must monitor their portfolios for crowding.

EHTH was not the largest stock-specific hedge fund insurance sector bet[…]

Hedge Fund Crowding Costs – SanDisk

Hedge Fund Crowding Costs – SanDisk

SanDisk (SNDK) was down 14% following a disappointing pre-announcement. This is a common occurrence for crowded ideas: SanDisk is the most crowded hedge fund bet in its sector, and crowded hedge fund Electronic Components picks tend to do poorly. These events illustrate crowding costs, particularly in the areas where hedge funds display a persistent lack of skill.

This piece analyzes hedge fund[…]

Hedge Fund Internet Software Crowding

Hedge Fund Internet Software Crowding

Hedge funds tend to pile into the same few stocks. In most sectors these crowded bets underperform. In previous articles we discussed the crowding of hedge fund energy as well as exploration and production bets. Internet software stocks show similar underperformance.
Hedge Fund Internet Software Aggregate
If markets were flat since 2004, the aggregate position-weighted hedge fund internet softwa[…]
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Hedge Fund E&P Crowding History

As we have discussed in earlier articles on hedge fund energy as well as exploration and production crowding, funds pile into the same few stocks. Over time these crowded stocks tend to underperform.

The following video shows the most crowded hedge fund E&P stocks over history, and their historical risk-adjusted performance:


The information he[…]

Hedge Fund Crowding Costs – Energy

Hedge Fund Crowding Costs – Energy

In recent articles we discussed shared long bets among U.S. hedge funds – a phenomenon called “crowding” – without quantifying its consequences. Crowding is costly to investors, fund managers, and allocators. A prime example of this is the Energy Sector:

Over the past 10 years the aggregate hedge fund long energy portfolio (HF Energy Aggregate) delivered negative risk-adjusted returns.
Since[…]

Pure Sector Factors and the Energy Cycle

Pure Sector Factors and the Energy Cycle

Separating the Signal from the Noise in the Energy Sector
In an article introducing pure sector factors, we illustrated how market noise obscures relationships among individual sectors, concealing industry-specific performance. As a result, most investors are oblivious of the underlying secular trends and are frequently blindsided by them. This obliviousness can be costly. For example, investors […]
Vanguard Wellington Fund (VWENX) – Market Timing

Vanguard Wellington Fund (VWENX) – Market Timing

Vanguard Wellington Fund (VWENX) is an excellent market timer with a track record of increasing exposures to factors that subsequently generate larger-than-typical returns.

Over the past 10 years, the fund returned approximately 7% solely through varying its factor exposures. This compares to an approximately 4% market-timing loss for the average medium turnover U.S. equity mutual fund:

[…]

Icahn's Technology Security Selection

Icahn’s Technology Security Selection

Should Investors Follow Icahn into Apple?
As we discussed in earlier articles, it is a mistake to treat all ideas of excellent managers with equal deference. Even great investors tend to be more skilled in some areas than in others. Carl Icahn is no exception.

Many investors follow the positions of Carl Icahn. His recent open letter to Apple’s CEO Tim Cook will cause some to follow Icahn into […]

Parnassus Core Equity Fund (PRILX) – Returns-Based Analysis

Parnassus Core Equity Fund (PRILX) – Returns-Based Analysis

Returns-Based Analysis and Fund Beta
In an earlier article, we discussed the failures of returns-based style analysis – a common method of estimating fund risk:

Returns-based analysis is usually flawed when portfolio risk varies over time.
Returns-based analysis may not even accurately estimate average or representative risk of the portfolio.
Flaws are most pronounced for the most active […]

Berkshire's Long Equity Position Sizing

Berkshire’s Long Equity Position Sizing

Generally, Berkshire Hathaway’s largest positions are not its best ones. If Berkshire sized all positions equally for the past 12 years, the risk adjusted return of long equity portfolio would have been approximately 5% higher:

Position sizing cost portfolio approximately 10% over the past three years.

Berkshire’s managers appear to have made some of their largest positions things they c[…]

Greenlight Capital's Energy Equity Security Selection

Greenlight Capital’s Energy Equity Security Selection

As we discussed in an earlier article, excellent investors are not equally proficient in all areas.  While Greenlight’s overall stock picking performance is stellar, it does not extend to all sectors. Its picks are excellent in technology and subpar in healthcare, for instance.  Results are mixed in energy.

The following is a chart of the estimated security selection (stock picking) return due […]

Pure Small Cap Performance

Pure Small Cap Performance

In recent months, the poor performance of small companies has led to a flurry of analysis. Unfortunately, most analysis overlooks small caps’ broad market risk, or beta, and fails to identify pure small cap performance. Consequently, this analysis is imprecise and its conclusions are inaccurate. Much more telling is Size Risk Factor – a pure small cap performance indicator. It reveals that small c[…]
iShares Core High Dividend ETF (HDV) Alpha and Beta

iShares Core High Dividend ETF (HDV) Alpha and Beta

iShares Core High Dividend ETF (HDV) is a low-risk fund that has consistently delivered positive risk-adjusted return.
iShares Core High Dividend ETF (HDV) – Historical Beta
U.S. Market exposure (beta) of the fund has varied in the narrow window between 0.52 and 0.60:

iShares Core High Dividend ETF (HDV) – Historical Alpha
The fund has consistently generated positive risk-adjusted return f[…]

Currency Risk and Local Currency Beta

Currency Risk and Local Currency Beta

Risk models and portfolio analysis tools often assume that all foreign securities have local currency exposure (beta) of one, under the convenient belief that reference currency performance due to local currency changes is simply local currency appreciation.

Reality is rarely this convenient. This standard approach misrepresents the true currency risk of most foreign investments. For example, a[…]

Pershing Square's Finance Sector Skill

Pershing Square’s Finance Sector Skill

Pershing Square’s Finance Sector Security Selection Performance
Pershing square has a phenomenal track record of stock picking. Over the past 10 years, it has generated approximately 200% risk-adjusted return from security selection in its long (13F) portfolio. If market were flat for the past 10 years, the portfolio would have gained approximately 200%. We call this risk-adjusted return αReturn:[…]
Greenlight Capital's Position Sizing

Greenlight Capital’s Position Sizing

Greenlight’s Long Equity Position Sizing
Greenlight’s top positions generally aren’t its best ones. It is common to assume that the top positions of skilled investors are their best ideas, but this is not always the case. If Greenlight sized all positions equally for the past 10 years, the risk adjusted return of long portfolio would have been approximately 20% higher.

We can’t know for sure w[…]

Artisan Funds' Security Selection

Artisan Funds’ Security Selection

Artisan International Fund (ARTIX) and Artisan International Value Fund (ARTKX) – Security Selection
Both Artisan International Fund (ARTIX) and Artisan International Value Fund (ARTKX) show excellent security selection (stock picking) performance over the past 10 years.

If all markets were flat for the past 10 years, ARTIX would have generated approximately 0% cumulative return from stock pic[…]

Paulson's Energy Sector Skill

Paulson’s Energy Sector Skill

Paulson & Co Energy Sector Security Selection Skill
One should be careful when handling Paulson’s energy picks.

A portfolio of Paulson’s long (13F) energy positions has lost ~50% on a risk-adjusted basis. ETFs with the same market and energy sector exposures as the energy portfolio have outperformed it. The historical security selection (stock picking) performance of Paulson’s 13F position[…]

Fisher Asset Management Security Selection

Fisher Asset Management Security Selection

Fisher Asset Management Security Selection Return — 13F Portfolio
The following is a chart of Fisher Asset Management, LLC’s estimated security selection (stock picking) return for all long positions over the past 10 years:

The analysis evaluated 10 years of 13F fling history for the firm. It estimated the returns the portfolio would have generated if markets were flat – stock picking perf[…]

Oakmark Fund Technology Skill

Oakmark Fund Technology Skill

Oakmark Fund (OARMX) Technology Sector Skill
In general, even fund managers that generate persistently positive active returns are rarely skilled across the board. They have stronger skills or employ stronger analysts in some sectors than in others.

The Oakmark Fund (OARMX) is no different. Over the past 10 years, it generated ~15% from security selection (stock picking):

Over the same […]

Hedge Fund Passivity

Hedge Fund Passivity

The Trend Towards U.S. Hedge Fund Passivity
We charted the historical cross sectional standard deviation of factor (systematic) and α (security selection) returns for U.S. hedge funds:

A surprising finding is that, even in midst of the 2008-2009 market volatility spike, the long positions of U.S. hedge funds were less differentiated from each other that they had been in the relatively lowe[…]

Value Partners High Dividend Stocks Fund — Security Selection

Value Partners High Dividend Stocks Fund — Security Selection

Value Partners High Dividend Stocks Fund has excellent long-term security selection (stock picking) performance. Results are ahead of 2/3 of U.S. mutual funds. However, inconsistency of security selection returns is a concern.

The fund generated approximately 3% annual gross return from security selection:

This is the residual return, or αReturn. It is the return in excess of the systema[…]


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