Hedge funds for all their stock market wizardry, as obliged to disclose their quarterly holdings. Good news for you, this makes is possible to copy what they are doing. It turns out that this strategy can work according to recent research from Barclays and Novus. Specifically, they found a return of almost 4% above the S&P 500 by copying hedge funds. Here’s what they found and how you can do it. Note that the idea that copying hedge funds always works is not entirely clear cut, other researchers have found that for different time periods is copying hedge funds is not a smart move. However, the researchers in the paper referenced above found good results in aggregate from 2004 to 2015.
Hedge Fund Disclosures
Hedge funds with over $100M in assets must disclose their holdings approximately 45 days after the end of each quarter. This is done via an SEC disclosure called a 13-F filing. It turns out this is useful information, though it does have some limitations. The first point is that the disclosure comes with a lag. You may not know about a hedge fund’s new position for months. However, most hedge funds of any size typically hold their investments for around nine months to a year, based on the median holding period, and so seeing the data with a delay isn’t necessarily an issue.
Secondly, hedge funds as their name suggests, can hedge. This means that even if there is a large position in a fund, it may be offset elsewhere by a short position that you’re not able to observe in the 13-F filing. For example, a manager may believe that Facebook is more attractive as an investment than Google. Therefore, they buy shares in Facebook and short shares in Google. From the 13-F filing you see their ownership of Facebook, but that’s not really the trade the hedge fund is making.
Both of these biases can be overcome by watching appropriate hedge funds, which is something the researcher recommend, those with longer term holding and those that avoid broad usage of arbitrage and short selling.
This is a copycat strategy, but it’s worth noting that off the bat, you actually have an edge. Say a typical hedge fund charges a 2% fee and also takes 20% of fund performance. That’s a pretty high hurdle to overcome, even for strong managers. If you’re copying a hedge fund, you don’t have to pay that fee. Therefore, you can be imperfect in following their strategy and you may still come close to their level of return simply because the high fees are avoided.
Is A Hedge Fund Right For You?
Just because you can copy a hedge fund, does not mean you should. We’ve seen a historically strong bull market in U.S. equities for many years. People forget that stocks can go down a lot. Hedge funds lose money too. Therefore, by copying a hedge fund you are still taking a high degree of stock-market risk. At the moment that’s not something people tend to worry about too much, but a few years of bad market performance would soon remind them of the risks here.
Furthermore, by copying a hedge fund you are only copying their long trades i.e. investments that will rise in value if they go up. Hedge funds can short too. This enables them to make money in bad markets, but if you’re copying only the long trades, then you won’t have that same balance. You may end up with a similar performance to hedge funds in good markets, but greater risk in poor markets.
How To Do It
Researchers found three main ingredients for a robust hedge fund tracking strategy. Firstly, track long-term oriented, stock-picking managers. Secondly track larger positions, those at 7.5% of the fund or more. Thirdly look for consensus across appropriate hedge funds. This means only owning stocks which multiple hedge funds apparently independently view as good ideas. Combining these three rules resulted in historic outperformance of the S&P 500 by almost 4% a year. Of course, this potential gain comes without hefty hedge fund fees. It’s also a relatively simple strategy because you only need to update holdings four times a year, when the quarterly 13-F filings are released. Plus commission-free trading means that it’s now even easier to implement.