Picking winning stocks is hard. As a financial advisor, you may be loath to cop to it, but academic research has shown that most professional (and individual) investors underperform their benchmark indexes. That is not surprising, of course, but underperformance may even be worse than that, given new research from Blackstar Funds (the report, called “The Capitalism Distribution,” was released in December 2008), that shows that roughly two-thirds of all stocks underperform their indexes over their lifetimes. Further, 40 percent are unprofitable investments, and nearly a fifth lose at least 75 percent of their value. That's a sobering assessment — and one that bolsters the argument for using inexpensive, passive indexes.
That said, would anyone deny that there are some managers who are very good at stock picking? Warren Buffett comes to mind; so do certain hedge fund managers, such as Greenlight's David Einhorn, Baupost's Seth Klarman and Appaloosa's David Tepper — all elite money managers who have proven they can pick winning stocks consistently over long periods of time.
The good news is you can look inside their playbooks. By reviewing publicly-available SEC Form 13F filings,?you can review the holdings of these managers — and any other professional money manager with assets of over $100 million.
I know what you're thinking. While 13F information is interesting, it is backward looking.?Can it really be of any value to investors? It turns out the answer is “yes,” as long as you use a structured and quantified process. In fact, you can use 13Fs from top managers as an “idea farm” for stocks that may well add alpha for your clients.
13Fs and Two Case Studies
The SEC posts electronic versions of 13F filings on its free, public EDGAR database (www.sec.gov/edgar.html) within a day after such filings are received. The data go back to late 1999, although the archives in Washington, D.C., contain paper records that go back further. Still, the most recent data on the SEC website is always 45 days stale, as 13F forms are not filed until 45 days after the quarter's end.
Typically, tracking 13Fs of leading funds works best with managers who employ long-term holding periods. (Buffett, for example, has stated that his favorite holding period is “forever”).?Longer holding periods will minimize the effects of high turnover (indeed, some managers may not even own the stock by the time the 13F is posted).
All an investor has to do to retrieve the holdings is to visit the web site, and search under “Company Name” for the desired fund or company. In our first case study below, we use Berkshire Hathaway (Search EDGAR for CIK #0001067983).
The major value added by good managers is their stock picking and not necessarily their investment timing. Still, it is important to backtest the managers' strategy in order to determine if it is appropriate for tracking. Many funds, such as the hugely successful Renaissance Technologies, are not appropriate for tracking due to their heavy use of derivatives. Likewise, SAC is probably not the best fund to track due to exceptionally high turnover in the portfolio. In fact, be aware that most hedge funds sell short, invest internationally, and/or use derivatives to hedge or leverage their ideas; it should be noted that these positions do not show up on 13F filings.
Despite these caveats, 13Fs can still help you make money. Let's take a look at Berkshire Hathaway's portfolio as an example. About 85 percent of the portfolio is concentrated in Buffett's top ten holdings.
The methodology we are going to use is as follows:
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Download all of the 13F quarterly filings.
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If there are more than 10 holdings, simply use the 10 largest holdings, as the majority of a manager's performance should be driven by his largest holdings — in effect, his “best ideas.”
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Equal-weight the 10 holdings.
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Rebalance, add/delete holdings quarterly, and calculate performance 50 days after the quarter's end.
It turns out that a simple portfolio that invests in Buffett's top 10 stock holdings, equal-weighted and rebalanced quarterly, beats the market by 10 percent a year from 2000 through 2008. A 2008 academic paper, Imitation Is the Sincerest Form of Flattery, examined a similar strategy for Buffett from 1976 through 2008 and found an 11 percent outperformance per year.
To accurately calculate returns, we included the portfolio effects of all stocks that are no longer traded due to delistings, buyouts, mergers, bankruptcies, and so on. We also include all dividends (cash, stock, special, etc.). Often, databases and backtesting software packages do not account for stocks no longer trading, which can heavily skew results. The dataset and performance figures are provided by AlphaClone, a website that I co-founded to help investors research and mimic the performance of the world's best hedge fund and institutional investors.
Investors can also create a fund of funds of their favorite managers.? For example, one could choose to follow the 20 “Tiger Cubs,” the talented portfolio managers trained by brilliant hedge fund manager Julian Robertson of Tiger Management. If you had invested in the 10 most popular stocks held by these managers, equally weighted them and rebalanced quarterly, you would have outperformed the market by over 13 percent a year from 2000 through 2008 and by 15 percent year-to-date in 2009.
Creating a funds of funds of favorite managers is a great way to uncover new stock ideas, but it can also make sense as a replacement for an equity allocation to the underlying funds.
Benefits and Drawbacks
Some potential benefits of using the 13F strategy instead of investing directly into a hedge fund or mutual fund include:
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Fees - Most hedge funds charge 2 percent management fees and 20 percent of profits (and a FOF layers on another 1 percent and 10 percent, respectively). The FOF investor would have to return 7 percent of alpha just to deliver a 10 percent return to the end investor.
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Access - Many of the best hedge funds are not open to new investment capital.
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Fraud & Transparency - Fraud risk is eliminated.
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Tax Management - Hedge funds are typically run without regard to tax implications, while the 13F investor can manage the positions in accordance with his tax needs.
Like any strategy, there are potential drawbacks. These include:
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Expertise in portfolio management - The investor does not have access to the timing and portfolio trading capabilities of the manager.
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Exact holdings - Crafty hedge fund managers have some tricks to avoid revealing their holdings on 13Fs, such as “shorting against the box” and moving positions off their books at the end of the quarter. The lack of short sales, international holdings, and futures reporting means that the 13F strategy's results will differ from the hedge fund results.
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Forty-five-day delay in reporting - The delay in reporting will affect the portfolio to varying degrees for different funds due to turnover. At worst, an investor could end up owning a position the hedge fund manager sold out of 45 days earlier. Forty-five days is an eternity in the capital markets.
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High turnover strategies - Managers who employ pairs trading or strategies that trade futures are poor candidates for 13F replication.
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Arbitrage strategies - 13F filings may show that a manager is long a stock, when in reality he is using it in an arbitrage strategy. The short hedge will not show up on the 13F.
There are numerous other ways an investor can use SEC 13F filings from top managers to generate ideas and alpha. Portfolios can be created with static or dynamic hedging, or by focusing on specific sectors and market capitalization tranches. Either way, monitoring what the best investors in the world are doing can be instructive — and profitable.
Mebane Faber is a portfolio manager for Cambria Investment Management and author of The Ivy Portfolio.