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Isolating the Best Ideas From Hedge Funds

Given recent interest in best idea strategies, we decided to analyze the inner workings of our very own Novus Conviction Index.

Shraman Ghosh
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In the aftermath of a difficult year for markets, many managers are concluding that sizing up their best positions is the key to beating the market. Some even introduced a “best idea strategy” that offers access to just five to ten names in their portfolio. This trend made its way into the realm of smart beta, too, with a few exchange traded funds (ETFs) and indices—including the Goldman Sachs Hedge Fund VIP Index—creating buzz recently.

Novus has curated indices based on various hedge fund factors since 2013. We call this family of data indices the Novus 4Cs: we track conviction, consensus, crowdedness, and concentration. The indices are constructed using a curated dataset of public filings, based on Novus’ proprietary manager classification methodology, which allows us to isolate the appropriate set of managers. Every quarter we publish the names and key stats for each index.

Of the Novus 4Cs, our research has shown that conviction is the most consistent factor for extracting alpha, while also limiting volatility. Given the current interest in best ideas, we’ve analyzed the recent performance of the Conviction Index, juxtaposed it with its sister indices, and looked deeper into a sector-specific variant of the same theme.

Bets That Show Conviction

Our Conviction Index tracks stocks that managers show conviction in, as proven by their willingness to size up a name. For us, a conviction investment is one in which a stock accounts for a significant portion of the manager’s portfolio—the exact threshold is proprietary, but it appears to be higher than some other indices in the market. The stocks with the highest number of manager conviction bets comprise our index. We limit the Conviction Index to the top twenty names. This index is up 14.77% YTD as of February 28, 2019.

(As a point of interest, the methodology for Goldman Sachs Hedge Fund VIP Index is to include the fifty stocks that appear most often in the top ten holdings of their tracked hedge fund manager universe. Their YTD return shows 13.65% as of February 28, 2019.)

Playing a Long-Term Game

The Novus Conviction Index has an annualized return of 11.84% since 2004 and has outperformed the S&P 500 in 66% of quarters.

Hedge Fund Conviction Factor

The statistics from the past ten years are notable, with a batting average of 65.95% and a win/loss ratio of 2.93x. Another merit of the index is its ability to tolerate risk, as seen below. Excepting a rough spell in 2016, it limited losses—as compared to the S&P 500 and MSCI World—in some of the most turbulent phases in global markets of the last decade.

Hedge Fund Conviction Low Volatility

2018 was particularly noteworthy, with the index performing well in February and December—the latter being hailed as the worst December for the stock market since the Great Depression. Steady outperformance coupled with low volatility has earned the Conviction Index the status of Novus’ flagship index.

Conviction’s Identity Crisis

Last year was also an anomaly, however, given the Conviction Index’s reputation for leading the 4Cs. While the Conviction Index ended the year with barely positive returns (as opposed to the S&P), it trailed the Concentration Index for eight out of twelve months, and furthermore, remained neck-and-neck with the Consensus Index. (The Concentration Index tracks the top twenty stocks for which hedge funds make up the highest percentage of their outstanding shares. Consensus is comprised of the most commonly held stocks by hedge funds, regardless of position size or value invested in each stock but instead based on number of owners.)

4Cs

This was a significant development considering conviction’s especially strong position in 2017. The reasons conviction fell behind were discussed previously, but can in part be attributed to the dominance of information technology (IT) names in the index for most of the year.

Hedge Fund Conviction 2018

In Q4 2018, big players in the communication services sector—such as Twenty-First Century Fox (FOXA), T-Mobile (TMUS), and Comcast (CMCSA)—were sized up in the index and replaced popular IT names like Amazon (AMZN), Alibaba (BABA), Alphabet (GOOG), and PayPal (PYPL). At this time share prices at tech companies were taking a hit due to numerous issues ranging from slowing growth to privacy concerns.

Juxtaposing this with the sector breakdown of the Concentration Index, we see how sector diversification played favorably for the Concentration Index in 2018, allowing it to end the year with a contextually impressive return of 6.15%.

Hedge Fund Concentration 2018

Whether 2018 was a bump in the road for the Conviction Index or the beginning of a new normal remains to be seen. Regardless, tracking hedge fund factors along multiple dimensions has shown its merit—especially during volatile years.

Novus Healthcare Index

As an analytics firm, our natural response to positive results is to isolate the subfactors driving the performance. Tracking sectors is nothing new to the smart beta world, with Forbes reporting that single-sector ETFs are attracting more than $300 billion worldwide. After watching interest grow, we built upon the Conviction concept and produced the Novus Healthcare Index, which tracks conviction among healthcare specialists.

Why healthcare? Our work with clients over the past decade and extensive research using Novus public filings data indicated that managers who specialize in healthcare tend to do a better job at selecting securities in the most specialized areas of the healthcare sectors; e.g., in mid-cap biotech. Our healthcare index builds upon this insight.

The index’s annualized return is 17.26% inception to date, seen below against the S&P 500 and S&P 500 Healthcare indices.

Our Healthcare Index also has a healthy batting average of 56.25% over the last ten years. The win/loss ratio, however, sits at 1.22x—much lower than the Conviction Index—meaning the average gain from a winner outweighs the average detraction from a loser by a smaller magnitude.

This makes sense when analyzing the drawdown:

While showing attractive alpha, this index has a much higher volatility profile than the Conviction Index and relevant market benchmarks. That said, investors looking for the highest-octane stocks in healthcare may still find this index interesting, and perhaps would do well to couple it with a hedging index.

We’ve noticed early returns for 2019 are quite encouraging, especially since the index ended the year at a low of -7%. Effective changes at the position level enabled the index to bounce back to over 19% in January and stand over four times higher than the S&P 500 and S&P 1500 Healthcare Indices at the end of February.

Takeaways

Best ideas strategies based on conviction are growing in popularity, but 2018 suggests it’s not the only factor investors ought to be tracking if they’re interested in hedge funds. While conviction remains a safe long-term bet, the index is most powerful when considered in context with the other Cs and an ever-shifting landscape. Tracking hedge fund factors across multiple dimensions will, we believe, help allocators profit from the aggregate wisdom of the crowd and help managers discover an additional pool of ideas.

Note: The Novus Conviction Index is not an investible product. In 2016, Novus entered into a data partnership with Barclays to develop an investable index family based on the Conviction Index. For further information please contact Barclays.

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