Contrarian Hedge Funds Outperform Momentum Mutual Funds

Hedge funds following contrarian strategies tend to realize higher returns than hedge funds and mutual funds that follow momentum strategies.

Hedge funds following contrarian strategies tend to realize higher returns than hedge funds and mutual funds that follow momentum strategies. The performance differential exists even after return anomalies and trading expenses are accounted for.

The authors of the study analyzed the style and performance of 589 mutual funds and 1,342 hedge funds over the period of 1998 through 2012. Rather than use reported return data, they relied on stock holdings listed in 13F filings. These are quarterly reports required to be filed with the Securities and Exchange Commission.

Mutual funds tended to hold larger portfolios as measured by the number of stocks and the average dollar value of stock holdings. Hedge funds tended to hold stocks with smaller market capitalizations, lower price-to-book ratios, higher credit risk and higher volatility, among other factors. Nearly all stocks held by hedge funds were also held by mutual funds, but just three-quarters of stocks held by mutual funds are held by hedge funds.

Mutual fund managers tended to buy stocks whose prices rose and sell stocks whose prices have dropped in the previous quarter. In contrast, hedge funds tended to buy stocks that declined in price during the previous quarter, but showed no preference between selling winners and losers. This implies that mutual funds follow momentum strategies for both buying and selling, whereas hedge funds are contrarian buyers.

Not all fund managers were momentum or contrarian-oriented, however. About two-thirds of mutual fund advisers are momentum-oriented, while about two-thirds of hedge fund managers are contrarian in their buys.

Mutual fund managers realized 0.13% in returns from active changes in their portfolios on a valuation and market-cap-adjusted basis, versus 0.27% for hedge funds. Once momentum is controlled for, mutual funds’ additional quarterly return dropped to just 0.02%. In contrast, hedge funds realized 0.25% in momentum-adjusted returns per quarter. The authors wrote, “mutual funds perform as well as a naïve momentum investor.” The comparatively superior adjusted performance of hedge funds is credited to stock-picking ability rather than following a strategy based on size, value or momentum anomalies.

“Style and Skill: Hedge Funds, Mutual Funds, and Momentum,” Mark Grinblatt, Gergana Jostova, Lubomir Petrasek, Alexander Philipov, SSRN, January 6, 2016.