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Tradestream Radio #2: hedge fund replication, insider trading, more

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Tradestream Radio #2: hedge fund replication, insider trading, more

This week’s episode of Tradestreaming Radio is up and ready for listen. Let me know what you think and if you have ideas for future shows. You can listen below, find the transcript below or download directly to you iPod/iPhone via iTunes — search for Tradestream or go here.

This episode includes

  • the huge insider trading probe into many of the largest US hedge funds
  • research networks (expert networks) and how they play a role in the investing process
  • interview with hedge fund replication research provider, AlphaClone CEO and founder
  • Ivory Tower Report: Smart investors think like economists (is that a good thing?)
  • Trend Watch: Seeking Alpha continues to grow and introduces its own investing app store

Transcript

Miller: Hey! This is Zack Miller at Tradestreaming Radio. You can find us at www.tradestreaming.com That’s where we blog, and a lot of the information that goes into this podcast is housed. You can subscribe to this podcast on iTunes, look for Tradestream.

I’m Zack Miller. I’m your host. This is the week of November 29th. We’ve got a great show lined up today. We’re talking a lot about research capabilities and how this may be impacted by the insider trading scandal that rocked the investment world this past week. We’ve got a great interview lined up with the CEO and founder of AlphaClone, which is a great research platform that helps investors piggyback on top of the best picks of hedge funds internationally. And, just a great show lined up. I hope you enjoy it, and check us out.

Always you can contact me at [email protected] I’d love to hear from you, any future suggestions you have for the show. Let’s get right into it.

Insider Trading Probe

Unless you’ve been living in a cave you’ve probably read something about a large insider trading inquiry that’s been building over the past three years. Last week The Wall Street Journal broke a story that numerous US hedge funds had been raided by the FBI, looking for evidence of large-scale insider trading. This is the largest inquiry of its kind, and has blazoned across newspapers across the world.

Beyond the merits of the case, and I don’t want to focus on that, we may do that in a future podcast, I wanted to focus more on the fascination surrounding hedge funds. Why are people so interested in it? Why do people care what Warren Buffet says? Why do thousands of people flock to Omaha every year to listen to what an aging octogenarian has to say about stocks?

I think people are really interested in hedge funds, as they’ve become the new celebrities. Many of them grace the pages of Forbes, and are some of the richest people in America. Hedge funds themselves have become the new benchmark. There’s a level of voyeurism here that investors are just completely in awe of these types of portfolio managers.

How do they get to be so wealthy? How do these guys come to manage so much money? I think the answer, and this is what I wrote in the book, comes in two forms; one is that they do better research. These are well-oiled research machines, whether it’s through technology, or through employing really smart analysts. These guys are looking under every rock, every stone, for the next investment opportunity.

The second is that they’re looking at companies that others aren’t looking at. This is their edge. Many firms, like SAC, focus on small cap companies that no one’s every heard of. There’s no research on these companies. They’re spending the time, and the energy, and money it requires to do good research on these companies.

According to a paper by Joseph Stiglitz, and this was a paper he published in 1980, the paper is called On the Impossibility of Informational Efficient Markets, Stiglitz writes, “Skilled investors are rewarded for the cost of information production; acquiring better information and/or better processing of available information that keeps markets efficient. Such ability would enable the skilled investors, efficiency insurers, to identify mispriced stocks and earn positive risk-adjusted returns as compensation for information production.”

Right? So, there’s an opportunity here for people to exploit, and hedge funds are doing it. But more than that we’ve actually seen a new strategy arise, and that’s piggybacking investors. I spend a whole chapter in my book talking about this. Part of the effort behind successful piggybacking of hedge fund investors comes from sort of discrediting the efficient market hypothesis.

I got my undergraduate degree from Harvard in Economics. Rammed down our throats was this idea that mutual funds could never beat the indices over the long-term. Some guys could do it in the short-term, but that was part of the statistical pattern, but very few, in fact almost none could show sort of this persistence of returns.

That changed in a paper that came out in 2005 called Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway, written by Martin and Puthenpurackal. One quote there is “Warren Buffet’s investment record suggests he is one of the most successful investors of all time.”

What they did was basically follow Berkshire Hathaway’s portfolio performance, and they stripped out some of the non-equity positions so they could follow just the stock positions within Berkshire Hathaway as a holding company. Then they created what was called the mimicking portfolio. A mimicking portfolio basically would be constructed of following Berkshire Hathaway’s monthly submissions to the SCC of their holdings, and changes in their holdings. The portfolio then would buy or sell those changes in the portfolio.

What they found was that there was significant alpha derived just by mimicking Berkshire Hathaway’s portfolio, above and beyond just having just given your money to Buffet to manage on his own. That was a huge move, not only moving towards sort of crediting hedge funds with sort of a skill level that we hadn’t been able to prove before, but also gave credence to this whole idea that, wow, by mirroring some of these guys’ activities you could actually build a back-tested smart portfolio, and that is where AlphaClone comes in.

AlphaClone is a research platform at that its backbone uses the regulatory filings of thousands of hedge funds and mutual funds around the US, and then creates a toolset on top to allow investors to devise and create back-tested investment strategies. For example, certain funds’ performances can be replicated by just picking the most concentrated holding of those funds.

There was research done to this effect by Cohen, Polk, and Silli called Best Ideas in 2009. They said, and I quote, “What if each mutual fund manager had to pick a few stocks, their best ideas, could they outperform under these circumstances? We document strong evidence that they could, as the best ideas of active managers generate up to an order of magnitude more alpha than their portfolio as a whole depending upon the performance benchmark.” Other funds, though, can be better replicated by picking the top two or three holdings.

Regardless of whether the fund could do that or not, AlphaClone provides a toolset to be able to test for that. It’s not enough just to say, “Well, Stevie Cohen is buying this stock. I want to buy this stock.” We’re talking about a full-blown investment strategy, a replication strategy, and AlphaClone provides a really robust tool to do that.

Actually I’m an AlphaClone user. So, I’m speaking from experience, just FYI.

I had the opportunity to ask AlphaClone’s founder and CEO, Maz Jadallah, what the platform is all about.

So, Maz, there are numerous products out there that track hedge fund holdings. What’s AlphaClone’s premise?

Mazin Jadallah, AlphaClone founder/CEO: Step one you should recognize that you’re probably not going to beat the market. Step two, having recognized that you should probably give your money to the world’s best minds to invest. If you can’t do that directly AlphaClone is a great way to do it.

I was curious about usages trends on AlphaClone, whether investors really knew how to craft an entire portfolio on the platform, or whether they were using it just for single stock ideas, so I asked Jadallah.

Jadallah: Both, and both to a very high degree. I’ve had conversations with managers where they combine their own insight and research on our site, and execute it, a trade that turned out to be successful. Then I also have just as many conversations with people who are waiting for the Tiger Cubs clone, or the value master’s clone, or the international clone. They like our core strategies and they apply those core strategies in client accounts.

I asked AlphaClone’s founder how fast the company was growing.

Jadallah: Well, we have thousands of registered users, hundreds of paying members. We have grown revenue by a 1,000% year over year. We continue to accelerate our revenue growth. We’re lean, but it doesn’t mean that we’re virtual. We’re real people here, me being one of them. I think the world having not ended in 2008, gave people the opportunity to see that the approach that we take is really transparent. It really does bring the best minds in stock picking, use them to derive investment strategies. There’s really no fraud risk, right? There’s no Madoff risk, I guess, in kind of what we do.

I think a lot of people were looking for a fresher approach to investing. I think the fact that we brought that to the table helped us. We think the future is bright.

Underneath the covers AlphaClone is really a content play. I was curious to ask Jadallah exactly how content plays into their recent foray into actual asset management. Clients can come in and actually have AlphaClone manage their money for them.

Jadallah: That’s really what we do. I mean our research platform is just a, it’s a technology platform and what it does is it generates all of these portfolios. Those portfolios are content. Really the better job we do at telling each clone’s story I think the interest that we’ll be able to get from our customer base and from investors, and really that’s about the content that’s on our platform.

You know we’ve got to a point now where I can’t do that all the time, and so we need a really good writer, online editor who can take our core strategies, who can take our thousands of clones and begin to tell stories around those clones that investors can understand and that are compelling, and then syndicate that content through, you know, the blogsphere and the internet, or to get the message out around what we’re doing.

That’s a really important element of success that I no longer can kind of do that all by myself, as you can imagine.

Maz, what about going forward? What keeps you up at night?

Jadallah: Our challenge will continue to be finding the right wrappers to put our research in, in order to maximize value for our clients and for us. So, we’ve got a research business. We’ve got an investment account business that applies that same research. We’ll introducing a proprietary strategy that is only available in investment accounts, or on a sub-advisory basis. I think that’s an important evolution for us.

Then that proprietary strategy may also be the basis for a pooled vehicle, whether it’s a mutual fund, or a closed-end fund, that will make it even easier for both institutional investors, professional advisors, and individual investors, because you go to the different share classes, for example, in the mutual funds, and make it that much easier for them to access our strategies. I think that’s kind of what the future looks like for us, at least over the next kind of 24 months.

Maz, do you have any recommendations for our podcast listeners as to resources you’ve found particularly useful, books, online, whatever?

Jadallah: I think there are maybe a few places to go. Obviously our help center on our site, www.alphaclone.com is a great place to start. There’s a lot of information there about what we do. The FAQs are a great place to start there.

Your book Tradestreaming (affiliate link) is an outstanding place to learn about piggyback investing, especially with the examples that you used. You make it very applicable for people to follow those examples in your book, so I would definitely point people there.

You know, Mebane Faber, who is associated with AlphaClone wrote a book about a year ago called the Ivy Portfolio (ditto), there’s a chapter in there about investing, piggyback investing, that I think is also very helpful.

I would say beyond just piggyback investing if people want to learn more I think about what it takes to be a successful stock broker, instead of reading books about hedge funds, I’d point them to a book that hedge fund managers love to read. It’s kind of a fun read too. It’s called Reminiscences of a Stock Operator, it’s a famous book. I’m sure you’ve heard of it. But I think that book really brings home what it really takes in order to be successful in stock picking, and why a vast majority of both individual and professional investors under-perform at that task.

As I’ve spoken about before, creating a portfolio in AlphaClone may be easy, the harder part that I find myself and from watching other investors use such platforms is getting people to stick to a strategy. We all think that we can outsmart the markets. We all want to do our own research.

Joel Greenblatt had a very interesting point when interviewed about the Magic Formula. Joel Greenblatt had 40% documented investment returns over a 20 year period. He created a modern day value investing formula based just upon two basic principles. He produces all of his information, puts his research online for free, for everybody to have access to. He even wrote a book how to do it.

In the interview they asked Joel, they asked him, they said, by putting this stuff out there and making it freely available, don’t you think that the Magic Formula over the future will lose its potency? Since everybody can do it, won’t that opportunity be arbitraged away? And he gave a very insightful answer. The answer he gave was that he didn’t think people could stick to a strategy like this, one that requires turning your brain off and following a rules based model.

AlphaClone provides that type of model. I asked Jadallah about that.

Jadallah: That’s right. It’s fascinating. There are a lot of behavioral techs I think that are also good kind of to read out there. But it’s fascinating that the behavior that you just described is the behavior that is easiest and most people do, and it’s exactly the opposite of what you should be doing, and there in is the challenge, right? As a human investor, right? You need to go a little bit against your own nature in order to succeed.

Miller: AlphaClone is the best and probably a myriad of different ways to mimic hedge fund performance. There some new EFT products out there, I think less than five, that use some type of hedge fund modeling. Typically they’re not looking at individual portfolio positions like AlphaClone is, and then constructing a portfolio around them. They’re just using merger-arb, long/short. They’re using basically hedge fund strategies to recreate sort of a fund that should somehow track hedge fund performance. There are a lot of sites that I call sort of Screening 1.0, they’re just combing through EDGAR, which is the SEC’s repository for all this type of information, and then listing holdings.

Market Folly is a great blog that takes that maybe a step further. So, not only is that blog going through, and the blog is run by Jay, who is a hedge fund analyst himself, not only is that blog sort of going through the filings, but because he’s an investor and he understands sort of what may be going on, Jay is trying to provide some type of running commentary behind some of those changes.

Jay also just launched a premium newsletter that comes out quarterly. It’s excellent work. Check that out as well.

Let me know if you have any ways, your own ways that you devised to track hedge fund performance.

Insider Trading Probe Probed

In the next part of the show I want to drill down a little bit into the insider trading/expert network issue that’s captivating investors around the world. A very interesting poll done on CNBC, and it was quoted by Henry Blodget at the Business Insider, and in this poll some 60% of viewers reported the idea of checking with industry insiders to get real time insights into business trends seems unfair. So, we’d like to talk about the investment playing field being level, right?

We have Reg FD data came in around 2000 that prohibited preferential disclosure within the investment industry and within corporate America. Essentially that meant that was the end of the old boys network. So, what has happened though in the vacuum that’s been left by Reg FD is that the expert network has really become the new old boys network. If we think of exclusive information, or the type of information that is harder for individual investors to get, it’s very easy for hedge fund investors to actually find an edge, and that’s what they get paid for, and that’s where the outsize profits are. According to that Stiglitz paper I quoted earlier in the show, that’s what hedge funds get paid for, is that informational inefficiency. They’re the efficiency insurers.

Back when I was at the hedge fund we used Gerson Lehrman Group, which was and is the largest, the 800lb gorilla in the expert network field. I write about this in Tradestream Your Way to Profits. We paid something like $8-12,000 per month to get three different industry, basically research coverage in three different industries.

I would basically call up with an information request, saying, “I’d like to research how well…” an example I brought in the book was how well a Gateway computer is now selling on the floor of Best Buy. Actually Gateway wasn’t selling at Best Buy, they had actually merged with a company called eMachines.

In turn I was put in touch with- typically they weren’t actually current Best Buy employees, but they were store managers, or the electronics department managers who had recently left the company and were doing some consulting on the side. I didn’t get any inside information. But the type of caller that I could get by knowing sort of what trends are on the floor, what customers were looking for, what was selling well when they left, and what wasn’t, was extremely invaluable.

Now, that’s not to say that an individual investor couldn’t do the same thing. I have friends that when they were investing in Apple, you know, 1000% ago, would go to Best Buys around the US and talk to store managers and get this same type of information. This is not exclusive information. An expert network just makes it a lot easier to obtain for an investor, so there is an advantage.

Henry Blodget in tongue and cheek form really sort of drills down into like why 60% of investors think that this is unfair. What do they think that Wall Street does all day? To quote, Blodget says, “Wall Street spends tens of billions of dollars a year checking with industry insiders in one way or another. It also spends tens of billions of dollars a year analyzing financial statements that are often inscrutable to folks who don’t work in the industry. And it spends tens of billions of dollars building real time trading systems, locating its computers close to the stock exchange for faster execution and so on.”

“Why does Wall Street spend all this money and go to all this effort? Because it has to. It’s the only way it even has a tiny hope of gaining an edge over other investors. As we’ve often noted the only way to win in the trading game is to beat other investors. You can get the market return by investing in an index fund. The only reason to trade therefore is to try to do better than the market return, and again, the only way to win the trading game is to win while other investors lose.”

A somewhat simplified view of trading. It’s not as zero sum gain, when a hedge fund gets, you know, outsized returns it doesn’t mean someone else is losing in an outside manner. Everybody can theoretically win.

But, obviously, you know, hedge funds get paid a premium. They typically take 2% on assets, plus a 20% performance fee on their profits. And, they can charge those fees, which are quite hefty if you compare it to an average mutual fund, or exchange traded fund, and ETF. They get paid because they can produce, and if they don’t produce the money is not sticky, and the money finds a home that can produce at that level. Put that in your pipe and smoke it.

Expert networks I think are here to stay. I can make a case, and I did on the blog that they are a good thing, even though compliance issues are sticky around these things. They do help the flow of information.

James Altucher was on CNBC the other day. He was pitted against a industry lawyer who was actually pushing for more regulations, as lawyers should. That’s sort of their incentive. Altucher took the whole side that we should completely relax our insider trading laws. You know, it made good conversation.

And there are cases, and you know, I point to some of these papers on my blog where it may make sense to relax some of the insider trading laws. Typically having some type of structure protects your individual investor from stocks being manipulated by insiders, and from insiders sort of raiding the corporate cookie jar. But, ultimately experts networks are an efficient way to transfer information among people. They’re not exclusive in the sense that they’re capturing information that is inaccessible to other people. It just makes it easier. We’ll see how this plays out.

Ivory Tower Report

Next up in Tradestreaming Radio we have the Ivory Tower report. In this section of the podcast we like to highlight a recent academic finding into the world of investing and economics. This week’s Ivory Tower report focuses on an article in The Wall Street Journal that summarizes a Caplan Miller piece on the correlation between IQ and economic beliefs.

I quote The Wall Street Journal, the authors found that intelligence supplanted education as the primary predictor of whether one took an economist’s typical point of view, education moved into second place, followed by party identification, Republican, and recent growth in income. The correlation between the views of intelligent people and professional economists offer “another reason to accept the economists are right, the public is wrong interpretation of differences in opinion,” these economists argue.

We can argue forever whether it’s valuable to have an economist’s point of view. Typically most economists are not accurate when it comes to short to mid-term forecasts. But, this is very interesting that intelligence, not education sort of correlates with a professional view of the markets. I will link to this paper and The Wall Street Journal article on the blog. And, you know, I hope this was valuable in terms of some food for thought.

Trend Following

Next up is Tradestreaming Trend Following. This is the part of the podcast where we look at and analyze current trends. I’d like to look at Seeking Alpha today. In full disclosure I used to work at Seeking Alpha. I’m still a minor shareholder. I used to run business development for them. What I wanted to discuss today was some of the trends coming out of that firm in particular.

They did launch a mobile site, a little late to the game, but they do have a mobile site so that you can access Seeking Alpha content via a phone, typically the iPhone. I don’t know if they launched an Android model, but they did launch- yes, they did. It’s compatible with all of them.

More interestingly they launched an app store. I wrote about this in the last chapter of my book about the future of investing, about the emergence of an app store for investors. I sort of prognosticated that this would come fourth from the online brokers, right? So brokers provide a platform and gateway into the end investor and can provide an ecosystem for third party applications to reach those investors. They’ve created APIs that enable third parties to link into their platforms.

It’s been very slow. E*Trade and Ameritrade both had made announcements about their APIs in this partner program. Look to see more of that in the future.

Seeking Alpha has been more aggressive about it. On October 10th they launched a platform for web-based investing tools on the site called investing apps. Those apps let users track, analyze, and manage their investments on Seeking Alpha. So, they’re taking third party companies like Validea which basically is a screen mechanism according to guru strategies. They’ve incorporated that content into the Seeking Alpha platform. So, somebody who is a Seeking Alpha user can download these things. They were free originally. They charge now on a monthly basis for these things. You can interact with third party content within the Seeking Alpha environment.

Seeking Alpha claims they’ve had 20,000 installs, and they’ve seen all-time traffic at a high. They quoted in a recent post by David Jackson, the CEO and founder, that during the week of November 7th Seeking Alpha had the strongest traffic in the history of the site, 7% more traffic than the second strongest week in the history, and 40% more than they saw in the same week year over year from 2009.

So, it looks like they’re hitting their stride. Community is growing. They’re trying a new monetization platform, which is this investment apps. Seeking Alpha looks to be one of the firms to beat going forward.

That concludes this week’s version of Tradestreaming Radio. Thank you for listening, and I hope you check in again next week.

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