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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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Differentiating your view on a stock

Last week, I interviewed Jim Valentine, author of Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts. For professional researchers, Jim emphasized the need to have a differentiated view on a stock.

From our chat:

I think another thing that may be getting more into the investment arena, in terms of best practice, is to identify the two to four critical factors that impact every one of your stocks. This kind of goes back into the time management thing. What I find is that there are a lot of really smart analysts who know a lot about other companies, but they don’t have a differentiated view from consensus on any particular issues that are going to drive the stock. Ultimately they become a company analyst, rather than a stock analyst.

So the best practice, in effect, is to do some research, figure out what are those two to four critical factors, and then focus all your time on those for your companies, as opposed to all the other factors out there that are, in effect, noise.

Pro analysts vs. the rest of us

This need to differentiate makes sense for equity analysts: ultimately, the good ones get paid to pick spots when their information and view on an investment diverges from consensus.

But I’m torn if this makes total sense for the rest of us.   How important is it for the majority of investors to do something completely off the beaten path?  We know that stocks with greater investor recognition typically do better than those with less.  Do we really need to stick our investing necks out to try and find the next $GOOG or $AAPL?

In my own investing, I tried for years to come up with original stock picks — either ones that no one was looking at or ones that everyone hated on.  Now, I’ve automated much of my investment process leveraging the Tradestream and spend much of my time finding strategies that take me out of the investment selection process.

Where is the line between being an investing contrarian and not getting swept along with every fast-and-quick investment fad and just doing things according to “the book”?

More resources

Learn more about the book and Jim Valentine

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Winning trade of the week: front running the hedgies

From the great-idea-but-really-hard-to-implement:

comes a strategy to find profits by uncovering lesser known stocks before the big institutional investors come and plunk their money down on ’em — essentially front-running hedge funds.

By looking at stocks varying investor recognition, Sloan and Lehavy found 4 ways that recognition and stock prices are related

  1. security value is increasing in investor recognition
  2. expected return is decreasing in investor recognition
  3. the above two relations are increasing in a security’s idiosyncratic risk
  4. financing and investing activities are increasing in investor recognition

Performance

The researchers find that those stocks in the decile of  stocks with the highest change in institutional ownership generate size-adjusted returns of 14.4% whereas the lowest decile generates returns of –11.0%.

Takeaways

Well, this is all nice and dandy but actually applying this strategy is quite difficult. In fact, according to Empirical Finance (h/t for bubbling this paper up)

As amazing as these results are, they are of little use to the investor because the returns and the change in institutional ownership are occur during the same quarter.  That is, the investor won’t know which stocks have the highest change until after the 14.4% return has already been generated.

Nevertheless, it appears as if the gains in the owned stocks point to an underpricing in the market.  In addition to the issue of returns and ownership occurring in the same quarter, we still don’t know a whole lot about what constitutes investor recognition — how investors encounter stocks and continue to drink from a particular issue’s tradestream.

How investors discover new opportunities

  1. David Jackson, founder of Seeking Alpha, always believed that investors would encounter smaller companies by way of researching their bigger competitors. In fact, we launched an advert product that enabled smaller companies and their IR firms to target investors researching larger ones.
  2. Companies like StockTwits provide an opportunity for investors to discover lesser-known stocks residing in the long tail.
  3. Peter Lynch, the scion of buy-what-you-know investing, encouraged investors to buy the stocks of companies they’re familiar with.  As tragically hip companies like Skullcandy and Pandora ready to IPO, investors are given opportunities to invest in firms that make products they use daily.
  4. creating backtested strategies that piggyback guru investors a la AlphaClone is something I’ve spoken about a lot on this site (and in my book) — though this helps less if you’re trying to find firms not widely owned on the Street

Regardless, with social media, the dissemination of good ideas in lesser know companies will be something studied, analyzed, and made profitable.  Good times.

More resources

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Hedge funds beefing up after good returns, inflows in 2010

The hedge fund industry certainly took a drubbing in the bleak market years which were 2007 – 2008.  But, they’re back and they’re back on the heels of good performance and inflows in 2010.  Credit Suisse released its 2010 Hedge Fund Industry Review (.pdf)  today.

Few highlights:

  • Hedge funds, as measured by the Dow Jones Credit Suisse Hedge Fund Index, were up 10.95% for 2010 after posting positive performance for seven out of 12 months
  • On an asset-weighted basis, an estimated 81% of funds have surpassed previous high water marks as of December 31, 2010
  • The industry saw an estimated USD $8.5 billion in inflows for the fourth quarter, bringing overall inflows to $22.6 billion for the year. This represents the largest annual inflows into the space since 2007
  • The largest inflows in 2010 were seen in the Global Macro and Event Driven Sectors, up $16.8 billion and $13.9 billion respectively, while the largest outflows were seen in the Multi-Strategy sector which lost $16.9 billion
  • Including performance gains, current hedge fund industry assets under management (AUM) grew to $1.7 trillion as of December 31, 2010, up from $1.5 trillion on December 31, 2009
  • Research of returns from January 1996 through December 2010, indicates that smaller hedge funds (less than $100M AUM), have historically outperformed larger hedge funds (greater than $500M AUM) by 3.95% annually

Check out the whole report here.

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Financial voyeurism and the tradestream

Voyeurism drives a lot of our activities online.  Admit it — you’ve definitely googled or facebooked an old friend with no intention of reconnecting.  You just wanted to peer into their lifestream.

Venture Capitalist Michael Eisenberg told me once that many of today’s successful online businesses are winners because they incorporate some level of voyeurism.

If investing is about learning, we’re always interested in what others are doing, but sometimes it’s hard to figure out.  To see what a large asset manager is doing, we can check public portfolio filings.  Other times, we pick up what others are investing in over a game of pickup basketball.

Regardless of how we get this information, we place a value on it (sometimes, even a value greater than our own opinions). The collective tradestream (and dissemination tools like StockTwits and SeekingAlpha) allows us to drop in on the investing party our friends are having — at any time.  Not only can we get ringside seats into smart investors’ every activities, but we get their rationales for doing so.

It’s pure learning — both cognitive and the emotion set behind the trade.

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Hedge fund index performance for December 2010

Final performance for the Dow Jones Credit Suisse Hedge Fund Index (“Broad Index”) is confirmed up 2.90% in December and up 10.95% YTD

Oliver Schupp, President of Credit Suisse Index Co., Inc., said, “The Dow Jones Credit Suisse Hedge Fund Index rose 2.90% in December, with nine out of ten sectors posting positive performance for the month. Managed Futures was the best performing sector, finishing up 5.42%. Positive performance was also seen in the Event Driven sector, which finished up 3.93%, however Global Macro remains the strongest performing sector in 2010 after posting positive performance of 2.67% in December.”

Performance for the Broad Index and its ten sub-strategies is calculated monthly. December, November and year-to-date performance numbers are listed below and are available at www.hedgeindex.com.

Category Dec 2010 Nov 2010 YTD 10
Dow Jones Credit Suisse Hedge Fund Index 2.90% -0.18% 10.95%
Convertible Arbitrage 1.16% 0.04% 10.95%
Dedicated Short Bias -5.86% -2.36% -22.47%
Emerging Markets 1.50% -0.38% 11.34%
Equity Market Neutral 1.74% -2.51% -0.85%
Event Driven 3.93% 0.15% 12.63%
Distressed 2.73% 0.33% 10.26%
Multi-Strategy 4.78% 0.04% 14.36%
Risk Arbitrage 1.14% -1.44% 3.17%
Fixed Income Arbitrage 0.61% 0.74% 12.51%
Global Macro 2.67% -0.52% 13.47%
Long/Short Equity 3.42% 0.46% 9.28%
Managed Futures 5.42% -4.11% 12.22%
Multi-Strategy 1.70% 0.30% 9.29%
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Playing not to lose sometimes means you lose

Everyone has seen pro basketball players commit fouls early in a game. The coach faces a conundrum. Does he

  1. Leave the player in the game: he may play to full potential and contribute
  2. Yank him: scared of fouling out of the game, he may play sub-optimally

This decision making process has always been kind of locker room chatter.  Until recently.  Earlier this month, 2 researchers from goliath asset manager AllianceBernstein and an academic from NYU Poly addressed solving this issue using financial research in a paper entitled, How much trouble is early foul trouble?

The researchers actually came up with a formula that’s so important, failure to heed it — a single incorrect decision — could decide the game.  The research shows that it is optimal to yank starting players on a “Q+1 basis” (when they commit one more foul than the current quarter.

For example

on January 20, 2007, the Cleveland Cavaliers visited the Golden State Warriors. With 4:45 left in the third quarter, Golden State starter Andris Biedrins  committed a personal  foul. After the free throw to complete the
three point play caused by his foul, the Warriors were leading by two points. This was Biedrins’s fourth foul and he was  therefore in “Q+1” foul trouble and should have been yanked, but Don Nelson decided to keep Biedrins in the game for more than four minutes, only substituting him out with 36 seconds left in the quarter.

Was the coach’s decision to leave the foul-laden player in the game correct?

During that time, Biedrins did not pick up another foul. Biedrins  re-entered the game with 8:20 left in the fourth quarter and the Warriors up 5. Then at the 5:46 mark, he picked up his fifth foul of the game. Again, Don Nelson again kept Biedrins in the game. Finally, with 1:06 left in the fourth quarter and a tie game, Biedrins fouled out.

Cleveland eventually won the game in overtime. And the researchers question Nelson’s decision to leave his player in the game:

Nelson had two chances to  yank  Biedrins when he was in foul trouble but chose not to. As we will see, Nelson’s decision was not an aberration for him;  that year, he rarely yanked foul troubled starters even though they were in foul trouble more  than any other team. But perhaps Nelson’s entire strategic approach was wrong.

Parallels to investing

If early foul trouble means that pro ball players should sit things out for the sake of the team, I think you could draw some parallels to investors running money.

  • periodic performance review: like athletes, investors of all sizes can judge performance at any time (returns, to some extent, are the ultimate performance metric)
  • high stakes, high stress: everyone in this game is playing f’real
  • decision making appears to be serially related: investors behave differently when they’re winning versus when they’re losing.  I remember walking into my portfolio manager’s trading floor to interview.  I waited patiently while he was on a call — after he hung up, he said, “&*(@!”.  I asked what had happened and he said dispassionately that he had lost $6M on a trade.  When I asked what he was doing with it, he said simply that he is selling it and moving on.

Clearly some investors — more traders than buy-and-holders — strike certain rhythmic patterns in their investing.  You have to behave differently when suffering big losses than you would when up big on a year.  The great ones know how to optimize this tradeoff and not simply double-down just to salvage a trade-gone-bad.

Has Harbinger’s Phil Falcone lost his touch?  He’s suffered redemptions, poor performance, trader exodus.  Amidst all this, he has made a career-impacting decision to invest heavily in a huge bet on a private wireless firm.  Is he playing with too-many fouls or is this the master’s equivalent of bench time?  History will certainly be the judge.

Source

Maymin, Allan, Maymin, Philip and Shen, Eugene, How Much Trouble is Early Foul Trouble? (January 7, 2011). Available at SSRN: https://ssrn.com/abstract=1736633

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Preliminary hedge fund index performance for December 2010

Key highlights for the month:

  • Hedge Funds bounced back after muted performance in November, as the Dow Jones Credit Suisse Hedge Fund index rose an estimated 3.01%. Nine out of ten sectors posted positive performance for the month. The industry is expected to finish up 11.07% for the year.
  • The Event Driven sector posted the strong performance in December due primarily to increased opportunities in the special situations arena. The largest gains were seen in the Distressed and Multi-Strategy sub-indices which were up 2.34% and 5.27% respectively.
  • Global Macro funds were also among the top performers for the month finishing up 2.75%. Managers found profitability in FX trades, where many shorted the USD against other emerging markets currencies. Managers also added alpha via commodities with long precious metal positions.
  • Managed Futures funds posted positive performance of 5.50%, helping the sector to recoup November losses. Performance was largely driven by gains from short term models, which were able to capture strong momentum in both equities and commodities.

Strategy Estimates

Index Dec-10 Nov-10 2010
Dow Jones Credit Suisse Hedge Fund Index 3.01% -0.18% 11.07%
Convertible Arbitrage 1.14% 0.04% 10.95%
Dedicated Short Bias -5.94% -2.36% -22.52%
Emerging Markets 1.71% -0.38% 11.56%
Equity Market Neutral 2.22% -2.51% -0.37%
Event Driven 4.16% 0.15% 12.89%
Distressed 2.34% 0.33% 9.84%
Event Driven Multi-Strategy 5.27% 0.04% 14.90%
Risk Arbitrage 1.24% -1.44% 3.26%
Fixed Income Arbitrage 0.63% 0.74% 12.50%
Global Macro 2.75% -0.52% 13.54%
Long/Short Equity 3.41% 0.46% 9.26%
Managed Futures 5.50% -4.11% 12.28%
Multi-Strategy 1.79% 0.30% 9.38%
Dow Jones Global Index 7.38% -2.16% 11.89%
Barclays Capital Aggregate Bond Index 1.31% -3.81% 5.54%
DJ-UBS Total Return Commodities Index 10.69% -0.35% 16.83%

Source
Early View: Dow Jones Credit Suisse Hedge Fund Index Estimated Up 3.01% in December