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Following the Smart Money

There appears to be opportunity in following hedge fund and institutional ownership, but not where you might think.

Much has been written in academic research about the concept of ‘Active Share’, or the amount by which a traditional institutional portfolio deviates from the composition of its benchmark. In essence the opposite of indexing, a high level of Active Share indicates that the fund manager is anticipating that certain stocks will outperform or underperform the index.

There is a significant amount of evidence to support the claim that the degree of Active Share is positively correlated to the benchmark-relative performance of the institution; and therefore, that high-conviction institutions outperform their low-conviction peers.

S&P 1500 Top 300 Stocks by Gross Hedge Fund Share

Source: S&P Capital IQ

In a recent study, we extended the Active Share concept to hedge fund equity holdings as reported in quarterly Form 13F Reports. We found that the best way to utilize the information asymmetry that aggregate hedge fund holdings appear to reflect, is not to mimic the holdings directly. Instead, we draw on the concept of Active Share to attempt to detect the highest conviction positions by way of ‘Hedge Fund Share’ or aggregate hedge fund holdings in a stock divided by the float of that stock. These high conviction positions have outperformed their respective benchmarks. For large cap’s, there appears to be additional value in selecting stocks with high levels of hedge fund holdings that are also out of favor with traditional institutions.

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