Two-thirds of hedge funds follow contrarian strategies—and are also the highest performing, research has shown.
Contrarian hedge funds, or funds that tend to buy stocks that have previously had low returns, outperform their benchmarks by 2.4% per year, according to the National Bureau of Economic Research’s Mark Grinblatt, along with Gergana Jostova (George Washington University), Lubomir Petrasek (US Federal Reserve Board), and Alexander Philipov (George Mason University).
“The superior performance of contrarian hedge funds is persistent,” they concluded, adding that the outperformance was a result of “strategies that are more complex than purchasing stocks with low past returns.”
The study examined the style and performance of 1,342 hedge funds, 589 mutual funds, and 2,894 other managers held by institutional investors from 1998 to 2012.
For almost two-thirds of managers, the researchers found that stock purchases tended to be contrarian, although their tendency to sell recent winners was less pronounced. About 80% of hedge funds that were contrarian in the first half of the sample period—roughly from 1998 to 2005—were also contrarian in the second half (2006 to 2012).
These funds’ most profitable trades were purchases of stocks sold by mutual funds following momentum strategies. Hedge funds that utilized momentum strategies, meanwhile, did not outperform their benchmarks, even when the benchmarks controlled for momentum.
“Despite the documented profitability of momentum, contrarian hedge funds exhibit the best performance,” the authors wrote.
More specifically, their quarterly portfolio rebalancing generated “significantly positive” alpha, outperforming both mutual funds and the one-third of hedge fund managers following momentum strategies. This outperformance was driven by their managers’ “superior” stock-picking skills, or “the ability to find underpriced stocks among losers that other investors avoid.”
“Contrarian hedge funds exhibit superior stock-picking ability that goes beyond a naïve style-based strategy,” the study concluded.
Read the full report, “Style and Skill: Hedge Funds, Mutual Funds, and Momentum.”