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How to create a hedge fund portfolio that beats the market (checklist)

In Tradestream your Way to Profits, I wrote about how smart investors can use hedge fund filings to create a wining portfolio. By tracking the holding information of some of the most successful investors on the planet, individual investors can piggyback on hedge fund returns.

Many in the media — including some people I believe are smart, intelligent investors — poke holes in these replication strategies.  I’m not sure of their motivations, but the data are clear: By methodically creating a portfolio that seeks to mimic specific hedge funds (not all are good candidates for replication), individual investors get a big piece of the returns many of these funds have generated for years. Here’s a webinar I hosed last year on the subject of cloning hedge funds.

My ‘hedge fund’ portfolio

I’ve been developing a Tradestreaming.com Guru Portfolio this for the past couple of years (testing for 1 and using it with client funds for 2). While the S&P 500 was essentially flat last year, my Guru Portfolio generated close to 6% before fees. Even more impressive, it’s up close to 190.3% over the past 3 years with a 13.4% drawdown.

AlphaClone has been indispensable to building this portfolio (that image is from AlphaClone). I wrote about how AlphaClone is the cure to investor insanity in 2009 and I still believe it’s a very important tool for all investors to build tested, defined strategies that build on the research done at the world’s top hedge funds.

The point here though is that just buying a stock willynilly that Carl Icahn is targeting on a buyout or that Warren Buffett just put $1B into, isn’t really a strategy. For hedge fund replication to really work, you need to spend the time understanding how certain funds can best be piggybacked.

There needs to be a method to the strategy for this to really work — one that removes and individual’s decision making (ah, I like this stock OR, nah, I wouldn’t buy that — it’s a dog!) throughout the process. I found this to be the hardest part of implementing this quasi-quantitative strategy.

How to build a custom piggybacked hedge fund portfolio

There are simpler strategies on AlphaClone that are just plug-and-play, no research needed. You can see 6 different ways people are tracking hedge funds which don’t require a ton of work. Some of these work amazingly well, but I personally wanted something customized to some of the things I’m working on at Tradestreaming.

Here’s how I built my Tradestreaming Guru portfolio and how you can begin doing it in just under 1 hour with AlphaClone.

1. Understand how funds can be tracked: Some funds are hard to replicate. From what I’ve seen the best funds to piggyback hold positions for at least a few months at a time, have a value approach, and don’t have a problem taking big swings on individual stocks (meaning, have a sizeable % of their assets in individual names).

*Important point: Sometimes (and AC helps here, too), it’s not an individual fund’s picks that are the most exciting. Instead, it’s the most popular stocks held by a family of funds (say, the Tiger Cubs). Or, the most popular (that’s its technical name) stock in a certain industry or market cap held by all hedge funds (say, technology or transportation).

Here’s a list of the most tracked funds on AC to get you started (though AlphaClone literally tracks thousands of funds):

alphaclone

2. Determine what your ideal portfolio looks like:  If you look at the list above, these funds perform pretty damn well (at least at the 3Y mark), but their clones are portfolios comprised of the funds’ top 10 holdings. If you tracked a handful of these funds, you’ll end up with a pretty large portfolio of individual stocks.

Before you begin, it’s important to envision what type of portfolio you want:

  • Do you want to design a portfolio of 100 positions or 10? 
  • Are you comfortable following picks from just one hedge fund or do you want more diversity?

I personally didn’t want a portfolio larger than 10-15 stocks (read below).

3. Determine which strategy will get you to your ideal portfolio: When you play around on AC, you’ll see that certain funds are best replicated by a strategy that buys their top 10 holdings. Others work better by just following the top holding. Still, some follow the newest holding.

I wanted an easy-to-manage portfolio of  about 10 stocks (to get diversity and focus on different sectors) and I didn’t want a portfolio of 100 stocks (10*10). Instead, I targeted funds that worked well by just buying their top or newest holding. If I’m following 10 funds, that would leave me with a 10 stock portfolio (1 stock from each fund).

4. Screen, screen, screen

I used AC to screen for funds that:

  • performed well
  • had high Sharpe ratios
  • lower drawdowns
  • I looked for returns over 3 to 5 years
  • and that replicated well by using a single stock pick to represent their returns

I was also looking for funds that had focuses on different sectors (like biotech or tech or small caps, for example).

5. Add these funds to a Fund Group

As you find the funds that fit your strategy, add them to what AC calls a Fund Group.

Once you’re logged in to AlphaClone, go ahead and click the Create a Clone Group button under the Your Custom Groups tab. The feature can be used to combine and filter a group’s holdings by sector and/or market capitalization then backtest performance.

Before we checked how each individual clone performed over time. Now, with a group, you can see how the whole portfolio performs. You can add or subtract funds to get your portfolio right.

I settled on a strategy that tracked 9 different funds. I’d suggest a portfolio that has more holdings in it. Occasionally, the funds I’m tracking held the same stock (Apple $AAPL was everyone’s favorite in 2011) and that meant I had few positions and the portfolio fluctuated more than I would have liked.

6. Rebalance quarterly

AlphaClone updates every quarter, a month after hedge funds file. You’ll see what was bought and sold and you can make any changes in your real-money portfolios based on the new names in the portfolio.

Creating a piggybacked portfolio works — both in practice and in the research.

Will it continue to work? Who knows, but like tracking insider trading, it makes sense that it should and AlphaClone is essential to doing this the right way.

Was this helpful? Let me know in the comments.

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How to piggyback top hedge funds more effectively (presentation)

In a recent webinar, I sat with Maz Jadallah, founder/CEO of AlphaClone, a software provider and investment manager enabling what I call “piggybacking strategies” of top hedge funds.

We discussed some of the objections investors have to creating strategies involving replicating hedge funds.  We also provided 5 tips to perform better using cloning strategies.  It was a intriguing session with some great questions from the audience — make sure you sign up to this blog to be notified of our next event.

5 Myths About Cloning Hedge Funds

View more presentations from AlphaClone

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FREE WEBINAR: 5 myths about cloning hedge funds

Join us this coming Monday May 9th @ 4pm ET for a free online discussion on the “5 Myths About Cloning Hedge Funds”.

We’ve been following hedge fund replication strategies (what I call piggybacking) since the early days of this blog and back to 2009 on NewRules. It’s not only a topic I like to analyze, but I’ve moved a lot of my own investment activity to leverage the power of cloning.

Readers of Tradestreaming will know that AlphaClone, a research platform that enables investors to backtest multiple cloned portfolios of the world’s best investors, has been helping to make piggybacking practical for all types of investors.

But investors I speak with still struggle with understanding the rigor in cloning — misconceptions about the strategy still abound.

So, I’ve invited Maz Jadallah, founder and CEO of AlphaClone, to address these issues.  In an upcoming webinar, we’ll discuss:

  • the effects on performance of the timing delay in disclosure filing
  • the role of luck in clone portfolio performance
  • the importance of the absence of hedge fund short positions from disclosures;

Space is limited. Click here to reserve your seat now.

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Tradestreaming Cascade (Week ending 3/26/2011)

A new addition to Tradestreaming, the Tradestreaming Cascade is a highlight reel of some of the past week’s most interesting information.  Much of this comes from my Twitter feed, @newrulesinvest.

How financial blogging landed me a book deal (New Rules of Investing): Blogging is hard to monetize.  Here’s one way financial bloggers can begin to build businesses off their work.

Why investors overpay for certain investments (The Economist): Liquidity and lottery tickets and why the carry trade fails at the wrong time and just below investment grade corporate bonds perform best. From Expected Returns: An investor’s guide to harvesting market rewards.

Trades busted in new FocusShares ETFs (ETF Trends): Scottrade’s new ETF line, Focus Shares, had multiple trades busted.  Some shares saw a 98% drop as Nasdaq canceled them.

Wealth managers refine niche marketing techniques (Registered Rep) : Growing reliance on segmentation of new business development by wealth managers.  This time, Indian Americans.

Investing as a form of peer pressure: teaching kids to invest young (MarketPsych): In an interview with Tile Financial, this money manager/sentiment data player digs deeper to help understand kids’ motivation to invest.

10 most tracked funds, fund groups and stocks (AlphaClone): Most popularly followed hedge funds and stocks held by these hedge funds as tracked by piggyback investment research powerhouse, AlphaClone.

Signup here to receive real-time updates from Tradestreaming.

 

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When following the fast money can be a good long term strategy

Stone Street and The_Analyst had an interesting piece yesterday that appeared on Zero Hedge.  Entitled Financial Voyeurism, Why You Can’t Beat Fast Money, the piece took to task all the excitement surrounding hedge fund’s public 13F filings (.pdf) every quarter.

According to Stone Street:

funds and asset managers with greater than $100 million in assets under management are required to report their holdings. The list includes exchange-traded or NASDAQ-quoted stocks, equity options and warrants, shares of closed in funds shares of closed-end investment companies, and certain convertible debt securities. Short positions are NOT included in the 13F. In addition, managers can request confidential treatment of their filing if they feel that their strategy would be compromised by the disclosure. This includes circumstances where the manager has an ongoing acquisition or disposition program. Confidential treatment can last for three months to one year. Lastly, it is important to note that the 13F must be filed no later than 45 days after the end of the quarter. Most funds wait until the deadline to report, as such they are lagging indicators.

The issue is that clearly, investors blindly following 13F followings in an effort to replicate hedge fund portfolios are missing crucial information.  Beyond the lag between buying and filing, not all the fund’s holdings appear in these filings.

So, the incessant race in the blogosphere to analyze these reports for any changes in holdings appears to be somewhat futile.  Fast money momentum players look to piggyback portfolio changes of guru investors in the hope that the market has not fully incorporated this information into current prices.

But, it works

The thing is, with certain investors like Mr Buffett, this strategy actually works.  According to a study I quote in my book, Tradestream, a piggybacking strategy that incorporated only positions included on public filings would achieve alpha close to that of Buffett’s actual portfolio.

The researchers found that Buffett, although touted as the king of value investing, was actually running a growth portfolio.  From Martin and Puthenpurackal’s Imitation is the Sincerest Form of Flattery:

An investor who mimicked the investments from 1976 to 2006 after they were publicly disclosed in regulatory filings would experience statistically and economically significant positive abnormal returns using various empirical tests and benchmarks.  This indicates the market under-reacts to the initial information that Berkshire Hathaway has bought a stock and is slow in incorporating the information produced by a skilled investor.

I understand that Buffett takes larger positions and his holding period is longer than your typical hedge fund.  And that matters.  It would be harder to replicate portfolio performance in a fund like Renaissance that has huge turnover in its portfolio and very short holding periods.

But there are a lot of funds that take bigger, more concentrated positions, like some of the Tiger Cubs, Paulson, Ackman, etc.  Sometimes, even just mimicking a fund’s best idea works.  What these blogs and services are doing in scrambling to reveal and analyzing quarterly filings comes from a good place but needs to be put in context.

Do it, but with class and rigor

I think the point here is not to throw the baby out with the bathwater and poo-poo portfolio replication in general.  On the other hand, mimicking anything that moves — cloning any hedge fund manager — doesn’t make sense either.  That’s dumb money.

What I’ve done after publishing my book is move more and more into rules-based portfolio replication.  But I did it with rigor. I  identified firms that take concentrated positions and hold onto them.  I them backtested them using AlphaClone (see why I called AlphaClone “the cure to investor insanity“) to determine which strategies come closest to mimicking their own performance.  For some funds, it’s their largest holding.  Others performance comes from the largest new holding.  Other positions include the most widely held tech stock, for example.

These portfolios do work but they require vigilance and methodology.   See the performance of one of our portfolios, the Tradestreaming Guru Strategy.

Source

Financial Voyeurism, 13-F Chasers: Why You Can’t Beat the Fast Money (Stone Street Advisors)

Martin and Puthenpurackal: Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway (SSRN)

Cohen, Polk and Silli: Best Ideas (SSRN)

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

tradestream radio, discussing investing and technology

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 Continue reading “Tradestream Radio #2: hedge fund replication, insider trading, more”

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Crowdsourcing vs. Piggybacking: An ongoing debate

Just returned from a mini-tour for Tradestreaming which ended with an editorial of mine appearing on CNNMoney.

CNN’s editors thought the tension between investing alongside guru investors (what I call, piggybacking) and following the crowd (which devalues individual expertise) was worth exploring (in 800 words or less).  It was a great topic and one that I didn’t give enough verbiage to in the book.

Part of this was laziness, part of it was in effort to keep the text short, and part of it was that crowdsourcing investment ideas is still really in its infancy.  While we can essentially clone hedge fund portfolios (with great tools like AlphaClone or great resources like MarketFolly), crowdsourcing tools are still finding their footing (I like Piqqem).

Here’s the crux of the matter:

So while it’s premature to say whether crowdsourcing can act as a standalone strategy, it may make sense for investors to tap the wisdom of the masses in addition to the other strategies they use to generate investment ideas.

The Internet and social media are truly changing the way we acquire information, research investments, and manage our portfolios. The playing field is more level than it’s ever been, and that’s a good thing. Happy tradestreaming.

You can read the whole article on CNNMoney , Follow the smart money — and the crowd

Photo courtesy of futureshape

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Using technology to mimic guru investors (Future of Investing)

This post was originally included as part of an ebook that I published alongside the launch of my book, Tradestream, entitled “Tradestreaming and the Future of Investing”. The content was so good I wanted everyone to have access to it. 🙂

*************

Piggyback investing is about following the “right” people.  In a lot of ways following overall sentiment of an online community is exactly what you want to avoid. The simple premise is that “crowd sourcing” is only valuable when you are able to accurately define and isolate the right crowd.  Accepting this as essential first, then any application that then can overlay real-time information about the “right crowd’s” moves is valuable. Here are just a few applications that can benefit from real-time information gathering:

  • Manager selection:  The AlphaClone platform allows you to tap the collective intelligence of groups of managers that are either predefined by us or defined by the use.  Some of our groups are dynamic in that the list of managers that make up the group change ever quarter based on some criteria. Take our High Concentration fund group: it selects the 25 managers each quarter that have the highest disclosed market value spread over fifty positions or less.  I could see a dynamic group that is constructed of the 25 managers that have garnered the highest votes for inclusion amongst the AlphaClone user community or the 25 managers whose fund page has had the highest visitor traffic over the past 30/60/90 days.
  • Stock selection:  our platform uses quarterly public filings to select the holdings that make up clone portfolios.  A real-time overlay that precipitates intra quarter changes in portfolio weightings for securities in the clone would be really interesting.  Real-time sources could be intra quarter public filings from the manager or managers in a clone (13G/13D filings), real-time analyst consensus recommendations (especially upside and downside “surprises”), or real-time events (bankruptcy, M&A).
  • Strategy selection: our platform allows investors to create and backtest clones based on different “clone strategies” (Top Holdings, Best Ideas, Popularity in top 20) and customize clones by employing hedging options and rebalance options.  We consider that simply a starting point.  I can see our community providing feedback on new clone strategies they’d like to see as well as tips on implementing clones.

I see the real time web as a new communications medium that definitely has relevance for investors and investment services but just like any new communications medium, how useful it will be will largely depend on how it is applied and by whom (i.e. yahoo stock message boards vs. twitter feed from “pro investor here”).

*—> Like what you see? Hey! Don’t forget to subscribe to the free Tradestreaming newsletter for updates, tips, and special offers

Mazin founded AlphaClone in 2008 with the simple purpose to empower the average investor by giving him intelligent, instant and transparent access to the world’s best fund managers.  Mazin was a 12-year veteran of technology-driven media businesses including roles at Time Warner and OpenTV.
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Financial product development a la AlphaClone

Interesting case study(.pdf) from Venture Capital and Private Equity Club (UCLA chapter) on the launch of piggyback investing platform, AlphaClone.

Combining an interview with founder and CEO, Maz Jadallah, the paper includes his comments that should provide a resounding recommendation for using blogging as a lead generation tool for premium financial products:

Jadallah: Hiring a PR firm turned out to be a disaster for us. They simply did not perform well. The important point here is what does a startup do when they have zero/limited budget for marketing. Answer: blog, blog, blog, use word of mouth, run affiliate programs, cold call reporters, try to get content syndicated on third party sites!!

Source

AlphaClone, LLC: Launching an Investment Services Business in the
Midst of a Financial Crisis (Undergraduate Journal)