Hedge Funds' Best Picks Show the Way for 2012

BOSTON ( TheStreet) -- Hedge fund managers tend to outperform during stock-market rebounds when individual investors are playing it safe. After this year's slump, analysts are expecting a brighter 2012, and hedge funds are gearing up with riskier bets.

Hedge funds, which cater to wealthy investors by chasing higher returns for bigger fees, haven't been living up to high investor expectations this year. Hennessee Group, an adviser to hedge fund investors, said its own hedge fund index is down 3% this year through October, compared with a 0.4% dip on the S&P 500.

John Paulson (Paulson & Co.)

"Renewed optimism about the U.S. economic recovery, Europe's ability to address its debt problems, and China's ability to avoid a hard landing resulted in a remarkable 'risk-on' phase," Charles Gradante, co-founder of Hennessee Group, said in an emailed statement. "It has been an extremely challenging investment environment. We have seen managers get whipsawed due to headline risks, especially related to the eurozone sovereign debt crisis."

Though returns have been poor and redemptions have been piling up since July, performance is starting to pick up, and investors might find guidance in picking stocks by following where the smart money moved during the third quarter.

Heavyweights in the hedge fund world are licking their wounds this year. John Paulson of Paulson & Co., whose haul of reportedly $5 billion last year was a record for a hedge fund manager, has seen his Advantage Plus fund drop 47% this year through September, according to several media reports that cite investors in the fund. Even Paulson's bet on gold has worked against him, with his gold fund reportedly down about 30% this year.

There have been some signs of a turnaround for hedge fund managers like Paulson. Hennessee Group said its hedge fund index rose 2.5% in October, the best monthly gain this year thanks to a rebound in riskier assets. However, the broader-market index S&P 500 jumped almost 11%, the biggest jump in two decades.

TrimTabs has more optimistic news for hedge funds in this riskier climate. Though popular perception may be to the contrary, hedge funds actually have beaten the performance on the S&P 500 over the previous six months, losing only 6.4% to the drop of more than 10% for the broader market.

Although TrimTabs says its survey of hedge fund managers reveals they remain downbeat on U.S. equities, sentiment is improving. Bearishness on the S&P 500 decreased to 41% in October from 57% in September, the highest of the year. Meanwhile, bullishness rose to 35% from 16%, the lowest level of 2011.

If the worst of 2011 is over for hedge funds, it may pay to look at how these managers have positioned their portfolios through recently released 13F filings. Hedge fund and investment managers who manage 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 third-quarter regulatory filings by some of the biggest hedge fund managers to examine where the smart money is moving. The most important trends for the quarter, broken down by sector, are highlighted on the following pages.

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