Allow me to let you in on a closely guarded secret among professional money managers. While they all talk a big game and make it appear that by investing with them you are close to being guaranteed market-beating returns, the truth of the matter is far different.#-ad_banner-#

In fact, in the aggregate, the majority even fail to beat the market. Add in the fees, costs and expenses of investing with the professionals, and it seems like a losing proposition.

I know this sounds sacrilegious, but the numbers speak for themselves. According to the finance blog Zero Hedge, nearly 90% of all hedge funds, 65% of large-cap core funds, 80% of large-cap value funds and 65% of small-cap mutual funds underperformed the market in 2012. 

These facts raise the question: Why do investors continue to pour money into professionally managed funds when the majority fail to deliver even market-beating returns? 

Well, the answer is that a few funds deliver outsize returns year after year. This outperformance by the minority keeps the attraction high for the professional money management business. Investors scramble to find the next hot manager and funds on an ongoing basis, which keeps the cash flowing into the pockets of the managers. 

The trick to the game is to find funds that are using strategies that will outperform the market. While this can be as simple as picking the right stocks, it can also be as complicated as mortgage collateralized debt obligations and electricity arbitrage. Fund investors need to anticipate what strategies will continue to or begin to work into the future. This, rather than past performance, is the key to picking winning money managers. 

Independent investors can be well served by observing the holdings of the top-performing funds every few months. This tactic is a critical part of my favorite stock-picking strategy. I use the top stock holding of the top-performing funds to find potential investments. I strongly believe that the top hedge funds, with their multi-million-dollar research budgets, can locate stocks with the potential to make substantial moves. (Notice I didn’t say bullish moves!) I then do my own research on these top holdings to see whether I agree with the manager’s views. 

Here are my thoughts on the top performing hedge fund’s top holdings.

Fortress Investment Group (NYSE: FIG)
​This publicly traded hedge fund is up nearly 44% this year. Managed by Michael Novogratz, the fund has more than $4 billion under management and runs four core businesses: private equity, credit, liquid markets, and conventional asset management. 

The fund is heavily biased toward the financial sector, and its top holdings are Nationstar Mortgage Holdings (NYSE: NSM), with 63% of assets, and Brookdale Senior Living (NYSE: BKD), with close to 12%. Here are my thoughts on each of these top holdings: 

Nationstar Mortgage Holdings

This mortgage loan servicer is Fortress’ largest holding by far. Nationstar boasts a nearly $5 billion market cap, gross profits of just over $190 million, and an astounding year-over-year revenue growth of more than 190%. However, I think the upside is over for the stock. Rising interest rates have slowed mortgage applications, creating potentially insurmountable headwinds. Technically, shares have peaked on the upside at $58 in mid-September. The price has consequently plunged to a low in the $50 range, bounced higher and just hit resistance at $54. I strongly think this stock is a great short right now; I wouldn’t be surprised to see it in the $40 range within the next 12 months.

Brookdale Senior Living

This senior living community operator has a market cap of nearly $3.4 billion, revenue of close to $2.5 billion and gross profits of $2.7 billion.  There have been several insider sales recently, with the executive vice president and a director dumping shares. The price has fallen from a high in the $30 range in July to a low of $25 at the start of September. It has since bounced to $28.50 but has recently dropped below its 200-day simple moving average into the $27 range. Despite the recent selling, the “Graying of America”  should continue to fuel growth in the senior living sector for the next decade. Buying on the next breakout above the 200-day simple moving average makes sense. My 12-month target is $33 on this stock.

Risks to Consider: Market risk exists for any stock investment. Always use stop-loss orders and position size properly no matter how confident you are in your analysis.

Action to Take –> I strongly believe that Fortress is wrong with its long position in Nationstar. I wouldn’t be surprised if the fund starts to lighten is position over the next several quarters. On the other hand, I see the pullback in Brookdale as a buying opportunity. However, waiting for a breakout above the 200-day simple moving average makes technical sense.

P.S. Is it possible for average investors to beat the performance of high-flying hedge fund managers — or even of investing gurus like George Soros, Carl Icahn or Warren Buffett? With a new system from StreetAuthority’s Michael J. Carr, it is indeed. In his free webinar, Michael shows investors how to leverage the holdings of over a dozen legendary investors to easily beat the market… or even the “gurus” themselves. To watch this free webinar, click here.