Hedge Fund Portfolio Analysis: Attribution and Fundamentals (Part 1)

Chapter 7 opens with two quotes. One from Bernard Madoff saying he can’t discuss his proprietary strategy, and one from George Soros about how it’s not about being right or wrong, but how much you make when right and how much you lose when wrong. That contrast alone tells you everything about why portfolio analysis matters.

In the previous chapter we did quantitative analysis on our fictional hedge fund FCM. Numbers told us what happened. Now we need to figure out why it happened. That’s what portfolio analysis does.

Why Bother Looking at the Portfolio

Here’s the thing. Performance numbers look backward. A fund could have great returns for five years, but if the analyst who drove those returns just left to start his own fund, those past numbers don’t mean much anymore.

Travers makes this point with a concrete example. Imagine you find a fund with amazing performance, mostly from healthcare stock picks. Then you discover the healthcare analyst left a year ago. Suddenly, you need to reassess everything. Performance analysis alone would never have flagged this.

When we finish portfolio analysis, we should understand:

• What drove historical returns (attribution)
• Strategy and style objectives
• Sector and market cap exposures
• How liquid the underlying portfolio is
• How the manager makes trading decisions
• Whether there are any outlier positions worth questioning

Attribution Analysis: Who Made the Money

FCM provided monthly long and short attribution data. Combined with exposure data from the due diligence questionnaire, this gives us a full picture.

First, some basics. Gross and net exposure are calculated like this:

Gross Exposure = (gross notional long + gross notional short) / NAV

Net Exposure = (gross notional long - gross notional short) / NAV

Gross tells you the total amount of bets. Net tells you the directional lean. A fund with 100% long and 50% short has 150% gross and 50% net.

The Long Book

Over FCM’s five-year history, the long book returned 9.6% cumulatively. For comparison, the Russell 2000 was up just 0.4%, the S&P 500 was actually down 0.9%, and the HFRI Equity Hedge Index was up 5%. So FCM’s long picks nearly doubled the hedge fund index.

The average monthly attribution from longs was +0.55%. The long book was positive 37 out of 60 months (62% of the time).

The Short Book

This is where it gets interesting. The short book declined 23% cumulatively over five years, and at one point was down as much as 63% (through February 2009). Remember, when shorts decline, the fund makes money.

The short book was positive 26 out of 60 months (43% of the time). That hit rate is similar to the Russell 2000’s decline frequency, but the magnitude of FCM’s short gains was significantly better than just being inversely long the market.

Year by Year Breakdown

2007 - Good year. Shorts were the star, declining 16% and contributing more than half the fund’s positive performance. Gross exposure ran between 155% and 180%, net between 47% and 66%.

2008 - This is where it gets really interesting. FCM showed exceptional timing. They pulled down gross and net exposure before the market crash, going from 165% gross in January to 108% in August. Net exposure dropped to negative 2% by July. They started adding back exposure in Q4, a bit early but ultimately right. Short attribution added 31.7% while longs detracted 20.9%. The fund was profitable in a year when markets collapsed.

2009 - But here’s the problem. FCM’s short book performed poorly in the recovery year. Shorts rose 39.3% when the Russell 2000 gained 27.2%. The long book underperformed too, gaining 22.6% versus 27.2% for the Russell. The fund’s low net exposure and bad short picks in March and April hurt especially, missing a huge rally. This is something to dig into during onsite interviews.

2010 - A mediocre year. The fund returned 9.8% versus 26.9% for the Russell 2000. Net exposure averaged 62% (the highest in the fund’s history), meaning they were positioned bullishly but still lagged. Underperformance was driven by both net exposure drag and some bad months in the long and short books.

2011 (through November) - The fund was down just 0.5% versus negative 4.8% for the Russell 2000 and negative 7.1% for the HFRI index. Outperformance came from short picks in January and strong performance in both books in March and July. One bad month in October (shorts rose 25.7% versus 15.1% for the Russell) dragged things.

Fundamental Analysis: Getting Into the Holdings

Here’s where things get practical. FCM refused to send full portfolio transparency via email but offered to show everything during onsite visits. Travers says this is common, not a deal breaker. If a fund won’t send the data, you write everything down when you visit. And if they won’t show it at all? Move on. There are nearly 10,000 hedge funds out there.

So without full transparency, what can you do? Use 13F filings. These are mandatory SEC filings that show a fund’s long equity holdings. They’re public, free, and updated quarterly.

Travers mentions several useful websites for 13F research:

• SEC.gov for official filings and 13F security lists
• SECinfo.com for searching all public filings by fund, person, or geography
• WhaleWisdom.com for viewing current and historical 13F holdings with portfolio analytics and heat maps

Building the Portfolio Picture

From the 13F filing, you get shares held and market values. You can calculate each position’s weight:

13F Weight = market value of position / total market value of all positions

But 13F filings don’t account for leverage. So if you know the fund’s actual long exposure (which FCM reported as 115% at end of Q3 2011), you can scale the weights up:

Scaled Weight = 13F Weight x actual long exposure

Now your position weights sum to 115% instead of 100%, which is more realistic.

One important note: Travers adjusts extreme outliers in the data. When a company has nearly zero earnings, the P/E ratio goes through the roof, like 2,500x. He replaces these outlier values with the group average. Some people consider this controversial, but it makes portfolio-level aggregates more meaningful.

What the Portfolio Tells Us

Sector Concentration

FCM’s long book was heavily concentrated in just two sectors: services and technology. The DDQ didn’t mention sector limits, which is a red flag worth asking about.

Within services, business services was the biggest sub-sector, with three companies representing nearly 20% of total long exposure. Within technology, semiconductors dominated at 13.8% of the overall portfolio.

This raises good follow-up questions: Does FCM have sector constraints? Is this concentration normal or unusual for this quarter? Do they hedge sector exposure with targeted shorts?

Market Cap Distribution

The DDQ said FCM targets small to mid-cap stocks. The 13F data confirmed this, with holdings ranging from $250 million to $2 billion market cap. Weighted average was just over $1 billion. Consistent with what they told us.

Valuation Measures

P/E Ratios - FCM’s long book skewed toward stocks with P/E ratios below 20, with the biggest overweight in the 10x to 15x range compared to the index. This is consistent with their claim of being a value-oriented fund.

Price/Free Cash Flow - FCM’s DDQ emphasized free cash flow as a key metric. Most holdings had reasonable P/FCF ratios, but three outliers stood out: hhgregg (50.3x), Bruker Corp (50.5x), and Sapient (41.2x). These are exactly the kind of positions you want to ask about. If a manager says they care about free cash flow, why do they own stocks trading at 50x free cash flow?

Key Takeaways

Portfolio analysis is about connecting the dots between what a fund says it does and what its holdings actually show. For FCM, we confirmed their value orientation and small-cap focus, but also found concerning sector concentration and some positions that don’t fit the stated philosophy.

The year-by-year attribution breakdown is especially useful. It shows FCM had great timing in 2008 but struggled with shorts during the 2009 recovery. That’s exactly the kind of pattern you want to explore during onsite interviews.

In Part 2, we’ll look at additional portfolio metrics, liquidity analysis, and position-level deep dives.

Previous: Chapter 6: Quantitative Analysis Next: Chapter 7: Portfolio Analysis (Part 2)