Why Hedge Funds Prefer Small Cap Stocks

Henry Truc  |

In the second episode of Showtime's new hit Billions, superstar hedge fund manager Bobby "Axe" Axelrod is surveying his team for alpha ideas. One poor trader suggested that "Apple has room to run." Axelrod was nonplussed. He then proceeded to explain the difficulties in justifying the firm's exorbitant "3 and 30" fee structure to its investors if all they're going to do is invest in a popular stock like Apple. Say whatever you want about Billions, as many have already, but that scene was fairly on the mark.

A new study by Morgan Stanley found that hedge funds looking for big returns are actually preferring to go smaller. In the study, Morgan Stanley analyst Adam Parker and his team break down the alpha opportunities of the $100 Billion Club, which consists of 42 companies on the S&P 500 whose market caps meet or exceed the threshold. Parker writes:

"The 42 stocks that are greater than $100 billion in market capitalization today represent $8.6 trillion in total size, or exactly half the S&P500. Yes, 42 stocks have the same total market capitalization as the next 458. Many hedge fund managers we talk to don't think they can generate meaningful alpha in stocks larger than $100 billion market capitalization. Further, some worry more about the efficacy of their asset gathering when pitching stocks this well "picked over". Either way, these 42 names matter deeply for the performance of most benchmarks, and the competitive impact of these companies affects nearly all US companies at some level. Hedge funds currently have an antimega-cap bias, underweighting these names in favor of small and mid-cap stocks. Is that smart?"

The study also found that correlation between megacap stocks is at relatively high levels from a historical standpoint, largely because of the macro-economic forces currently affecting the market. To be clear, the study is not about whether small-cap stocks are better than mega-cap stocks, but rather how investors may be able to generate alpha opportunities by differentiating the megacaps.

Of course, investors should already know this by now. For all the investment qualities of megacaps, upside potential usually is not an area that they lead in. And for those looking for major profit opportunities, it makes sense to look at smaller, emerging growth companies that are on the come-up.

Henry Truc is the editor of Equities.com. You can follow him here and on Twitter @henrytruc.

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