Holdings Concentration and Hedge Fund Investment Strategies

Abstract

This article examines the risk–return performance of concentrated positions of hedge funds in large-cap and small-cap stocks. The research shows that small-cap stocks in which hedge funds have concentrated positions earn higher future returns than those that are not part of hedge funds’ concentrated holdings. Also, stocks that are part of the concentrated positions of hedge funds display higher downside risks and relatively large downside returns during periods of market turmoil. The results presented indicate that hedge fund managers are skilled in making equity investments under different degrees of market efficiency. The authors’ findings have two practical implications: (1) hedge funds that hold concentrated positions in small-cap stocks may outperform their peers and (2) investors may be able to improve the performance of their equity portfolios by monitoring hedge funds’ positions in small-cap stocks.

TOPICS: Portfolio theory, portfolio construction, equity portfolio management

Key Findings

• • Stocks in which hedge funds have concentrated positions earn higher future returns and display higher downside risks than those that are not part of hedge funds’ concentrated holdings.

• • The above-mentioned effects associated with hedge funds’ concentrated positions are stronger for small-cap stocks than large-cap stocks.

• • Results imply that monitoring hedge funds’ positions, especially in small-cap stocks, may improve the performance investors’ equity portfolios.