Evaluating Hedge Fund Portfolio Data and Construction (Part 2)

In Part 1 we looked at how to get portfolio data from 13F filings and started breaking down Fictional Capital Management’s long book. Now we continue with more portfolio metrics and, more importantly, the liquidity analysis that catches the fund manager in a contradiction.

More Portfolio Breakouts

Travers continues slicing the FCM portfolio by different fundamental metrics. Each one gives you a different angle on what the fund is actually holding.

Earnings Growth - Nine of the 22 companies in FCM’s long book had negative earnings growth over the past 12 months. That is almost half. On the flip side, three stocks (Zumiez, Micrel, GSI Group) showed strong growth. This kind of split immediately gives you something to ask the manager about. Why hold so many companies with declining earnings?

Short Ratio - This is the number of shares sold short divided by average daily volume. Think of it as “days to cover” - how long it would take short sellers to buy back their shares. FCM’s portfolio had a weighted average short ratio of 9.2, but a few stocks were much higher. Allegiant Travel had a short ratio of 23.2. That is a lot of people betting against a stock that your fund owns. Worth asking about.

Return on Equity (ROE) - ROE measures how much profit a company generates with shareholder money. The good news for FCM is that all companies in the long portfolio had positive ROE. The values were well distributed. But here’s the thing, ROE can be misleading because management can boost it by taking on more debt. Travers mentions DuPont analysis as a way to break ROE into its components and see what is really driving the number.

Beta - The weighted average beta was 1.47, meaning the portfolio was about 47% more volatile than the market. Most stocks were clustered around the mean. Only Allegiant Travel had a beta below 0.5, and only Diodes Inc. was above 2.0.

Liquidity Analysis - Where Things Get Interesting

This is probably the most important section of the chapter. Portfolio liquidity tells you how quickly a fund can sell its positions without crashing the prices.

FCM manages a small-cap fund with about $275 million in assets. Their manager, Jaime Wernick, told Travers during the initial interview that 90% of the portfolio could be liquidated within 10 days and the entire portfolio within a month.

So Travers did the math himself. Here is the approach:

1. Take the 90-day average volume for each stock
2. Multiply by current price to get average dollar volume traded per day
3. Assume the fund would not want to trade more than 25% of daily volume (to avoid moving the price)
4. Divide the position size by that discounted daily volume

The result? Two positions (Vicor Corp and GSI Group) would take more than 30 days to liquidate. The average across the whole long portfolio was 12.9 days. And when you compare what Jaime said versus what the numbers show, the picture does not match at all.

For example, Jaime said 80% of the portfolio could be liquidated in 10 days. Travers’ analysis showed only 58% at the 25% daily volume assumption. Jaime said 100% within 30 days. The projection showed only 92%.

But here’s the problem - it gets worse. FCM stated their maximum capacity was $500 million. At that asset level, four stocks could not be liquidated within one month, and only about 10% of positions could be liquidated within ten days. That is nowhere near the 80% Jaime claimed.

The Follow-up Questions

Travers outlines smart next steps after this finding:

• Pull historical 13F reports to see how liquid the portfolio has been over time, especially during 2008
• Request an independent liquidity report from the prime broker
• Ask if there were any securities in the past that were hard to trade
• Challenge the manager on how the portfolio stays liquid at maximum capacity

That last point is critical. When small-cap hedge funds grow, they face a choice: invest in larger, more liquid stocks (which changes the strategy) or hold smaller positions in illiquid names (which means more positions and potentially a different portfolio). Either way, past performance may not tell you much about what happens at larger asset levels.

Peer Group Comparison

Travers compares FCM’s portfolio fundamentals against the peer group. The standout finding: FCM’s average market cap was significantly below all four peers, and the average trading volume was multiples lower. FCM also showed lower earnings growth, higher short interest, and higher P/E ratios.

This makes sense. FCM is a small-cap specialist while the peers lean toward mid- and large-cap stocks. The comparison helps explain the historical differences in performance and statistical measures like regression betas.

Historical Portfolio Analysis

Travers downloaded seven quarterly 13F reports for FCM (March 2010 through September 2011) and ran the same analysis on each one. This is where you start seeing patterns over time.

Key findings from the historical data:

• Market cap stayed in a tight range, confirming FCM is consistently small-cap focused
• P/E ratio was mid-range historically, but the PEG ratio and price-to-free-cash-flow ratio were both at their peaks. Since FCM says free cash flow is important to their analysis, this is worth questioning
• Short ratio was trending up, with 2011 values all higher than 2010
• Technology and Services sectors dominated the portfolio, consistently accounting for the biggest allocations
• Health Care and Financials barely appeared, with only one stock each over the entire review period
• Industrial and Basic Materials allocations trended down steadily

On liquidity over time - the historical analysis confirmed the problem. The average days to fully liquidate the long portfolio increased steadily from 52 days in March 2010 to 60 days in September 2011. The liquidity gap between what Jaime stated and what the data shows is real and persistent.

Trade Analysis

Travers asked FCM to provide trading history for specific holdings. They analyzed hhgregg, Inc. as an example. The idea is to see how the fund manager reacts to events in real time.

When reviewing trade history, Travers looks for days with unusual volume, extreme price moves, major market news, and company announcements. He creates a timeline and then asks the manager about specific decisions. Why did you buy here? What happened when the company announced earnings? Did you add or trim?

This approach does two things. First, it shows you how the manager actually trades, not just what they claim to do. Second, it signals to the manager that you have done your homework. Travers makes an important point here: hedge fund managers, who tend to be competitive and type-A, actually respond better when you challenge them with informed questions rather than just letting them go through their standard presentation.

Why All This Preparation Matters

Travers wraps up with something that stuck with me. The whole point of this deep portfolio analysis is not just to fill spreadsheets. You are building a picture of:

• What type of investor the manager really is
• How they behave under stress
• Whether their process is consistent
• How the team works together
• What each team member actually contributes

You cannot buy past performance. But you can develop conviction about whether this fund will behave the way you expect in the future and how it fits with the rest of your portfolio.

The next chapter moves from spreadsheets to face-to-face. Travers takes all these questions and findings into the onsite interview, where you get to see the operation up close. That is where the real judgment calls happen.

Previous: Chapter 7: Portfolio Analysis (Part 1) Next: Chapter 8: Onsite Interviews (Part 1)