40 Hedge Funds' Best Stocks Show the Way for 2012 (Update 1)

TrimTabs data on hedge fund performance in December added in this update

BOSTON (TheStreet) -- Hedge fund managers tend to outperform during stock-market rebounds when individual investors are playing it safe. After a miserable performance during a volatile 2011, that outperformance is still missing as hedge funds pared risk and haven't participated in this year's rally.

Hedge funds, which cater to wealthy investors by chasing higher returns for bigger fees, did not live up to high investor expectations this year. Hennessee Group, an adviser to hedge fund investors, said its own hedge fund index fell 4.3% in 2011, compared with a flat finish for the S&P 500. Hennessee Group's hedge fund index perked up in January, rising 2.5%. However, that trailed a gain of more than 4% for the S&P 500.

Bill Ackman, Pershing Square

"January was a good month for hedge funds. After a 4.6% decline last year, the industry has a more positive outlook for 2012," Lee Hennessee, managing principle of Hennessee Group, said in an emailed statement. "It is encouraging to see a respectable gain even with managers conservatively positioned. Looking forward, managers are still cautious but are optimistic on the potential to generate positive alpha."

A solid performance in January still doesn't wash away a bad December for hedge funds. TrimTabs Research estimates that the hedge fund industry lost $7 billion in December as industry assets fell about 8% in 2011. Assets are at their lowest since February 2010, TrimTabs said, which is in part because of performance. From May 2011 onward, hedge fund performance was negative in every month except October, TrimTabs added.

While it is encouraging that performance is starting to pick up to start 2012, investors in those funds likely aren't happy that hedge funds failed to deliver during tough times. Charles Gradante, co-founder of Hennessee Group, says that after several months of treading water, managers may be primed for a strong turnaround this year.

"The top-performing managers were positioned for a January rally and were long stocks that underperformed in 2011," Gradante said in an emailed statement, arguing that stocks have rallied this year on fundamentals rather than economic or political news. For that reason, investors might find guidance in picking stocks by following where the smart money moved during the fourth quarter.

The first place for investors to look at hedge fund positioning is the spate of recently released 13-F filings. Hedge fund and investment managers who oversee more than $100 million are required to disclose their equity holdings, options and convertible debt on a Form 13F filed to the Securities and Exchange Commission within 45 days of the end of a quarter. Funds aren't required to report short positions betting on declines, derivatives, bonds or currency bets.

TheStreet pored over more than 40 fourth-quarter regulatory filings by some of the biggest hedge fund managers to examine what the smart money bought before we entered 2012. The most important trends for the quarter, broken down by sector, are highlighted on the following pages.