How Hedge Funds Are Making Billions in Healthcare

Healthcare stocks have been on a tear recently and have nearly doubled (on average) from January 2013 through March 2015, the date range for this analysis. Looking at the performance of the S&P1500 by industry, Healthcare is the highest-performing sector by a wide margin, trouncing IT, Consumer Discretionary, Industrials, and the dividend-rich Utilities sectors. Buoyed by the Affordable Care Act, aging baby boomers, as well as increased global demand for medical devices, the sector shows no signs of cooling.

Cumulative return of the S&P 1500 by sector (January 2013 – March 2015)

Hedge Funds Increase Exposure

This outperformance has not gone unnoticed by the hedge fund industry. While the index weighting of healthcare grew due to the recent outperformance, hedge funds have moved aggressively into the sector.

Consider this: in 2013 hedge funds were underweight the sector relative to S&P 1500 by almost 2%. But recently, they have moved their dollars to Healthcare, and are currently overweight the sector. Here is their relative weight through time as tracked by the Novus Alpha platform.

Relative weight of hedge funds to the Healthcare sector (January 2013 – March 2015)

What This Means for Hedge Fund Investors

Given the increased importance of the Healthcare sector to hedge funds, the question that every investor should now be asking is whether hedge fund managers actually pick stocks that outperform the broad Healthcare index, or are they simply chasing a different flavor of beta? The answer surprised even us. They are chasing some beta. But they are generating tons of Alpha in the sector as well. Let me briefly explain how we got there. First, we took every hedge fund manager that files with the SEC and constructed a comingled, value-weighted portfolio of all hedge funds. We call that the Hedge Fund Universe (HFU) and it currently tracks over $2T in long market value. Next we ran our own attribution framework called Novus framework on that portfolio. Speaking simply, Novus Framework allows us to decompose returns and understand the portion of returns attributable to market volatility versus picking stocks.

Below you can see the results, so let’s digest them. The sector contributed 1,088bps of cumulative return since Jan 2013 (right most column in the below table). Of that, 623bps were simply a result of market movement and 301 was due to being in the Healthcare sector. But an extra 167bps was generated by hedge funds picking the right stocks within the healthcare sector. This number is the largest of all sectors. So, while there was beta to be had for sure, Hedge funds did their jobs and picked stocks that also generated Alpha. That has made the sector a godsend for hedge funds in the recent years.

Novus Framework on Hedge Fund Universe by sector (January 2013 – March 2015)

Novus Framework on Hedge Fund Universe by sector: Security Selection and Sector effect only (January 2013 – March 2015)

Greatest Wins in Healthcare

Over the period analyzed, Hedge Fund managers invested in 900 unique Healthcare stocks, 68% of which were profitable. More importantly, the average contributor made managers 1.92Bps, while the average detractor cost only .22bps – a great risk reward ratio.

The biggest contributors were Valeant, Allergan and Actavis, followed by Gilead and Thermo Fisher.

Digging deeper

If you assume that all hedge funds generate the same amount of alpha in the Healthcare sector – you would of course be mistaken. While on average, hedge funds picked outperforming stocks, many funds detracted value. Looking at just the ones that have managed to outperform, we constructed a list of the top healthcare stock pickers among hedge funds from 2005-2014. Contact us for more information.