Hedge funds were some of the biggest winners during the the carnage of the financial crisis but the performance of the sector in the years since has been pretty lacklustre. With bullish sentiment on both sides of the Atlantic driving equity prices to dizzy heights this year, many of these smart money investors have been stung by their short selling positions. But while few private investors will lose any sleep over the pain felt by hedge funds and their infamous ‘2 and 20’ fees, it’s still possible to borrow their best ideas and beat the market.

Recently I wrote about how the analysis carried out by hedge fund managers in pursuit of short selling opportunities can be useful to regular investors. In particular, the level of so-called ‘short interest’ in a stock can be a red flag that may signal fundamental flaws buried deep in a balance sheet. Equally, it could be that these stock pickers think that the company in question is simply overvalued and ripe for a fall.

Short selling can suck...

In practice, short selling has been a total dog of a strategy since late 2009 because growing confidence has led to a relentless rise in the price of equities. For funds that like digging around for overvalued and fundamentally flawed stocks, that’s been bad news because even suspect shares have been swept up in the euphoria. According to Goldman Sachs the situation means that the typical hedge fund generated a return of just 4% in the first eight months of 2013, compared with an 18% gain for S&P 500. Dig deeper into those rather paltry returns and you’ll find that it’s those short positions that have really done the damage to many of the 708 hedge funds under scrutiny. Goldman’s analysis finds that the 50 shares with the highest short interest as a share of market cap actually increased in price by an average of 30% during the period.

...but hedge fund stock picks often outperform

But while shorting has proved to be such a fruitless strategy for hedge funds lately, the performances of their long-only picks have actually beaten the market. The typical hedge fund has 63% of its long-equity assets invested in its ten largest positions and it turns out that these are often market-beating calls. In fact, so predictive are those top ten stock holdings that Goldman tracks a basket of…

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