Profiting from Hedge Funds E-Book

John Konnayil Vincent

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 351

Veröffentlichungsjahr: 2013

Beschreibung

Learn to apply the strategies of top hedge fund managers to your personal investment portfolio The most successful hedge fund managers and superstar investors outperform the markets impressively, while most fund managers--and individual investors as well--usually underperform the market averages. Based on the figures released by the Edgar System each quarter, this book analyzes the performance of hedge fund managers controlling at least $100 million in Assets Under Management to help other investors close the gap between themselves and the industry's top fund managers. With model portfolios that produced solid returns, examination of the tactics of the best fund managers, and a set of effective strategies for sound absolute returns, Profiting from Hedge Funds is the perfect guide for investors who want to improve their game by learning from the best. * Includes fascinating insights into the investment styles of the most successful hedge fund managers * Features model portfolios based on the holdings and activity of high-performing money managers * Offers key lessons for success that work across all portfolios

Leseprobe

Contents

Acknowledgments

Preface

Part One: Tracking 12 of the Greatest Money Managers

Chapter 1: Introduction

13Fs: A Window into Hedge Fund Activity

Filtering 13Fs for Relevant Activity

Raw 13F Filings from EDGAR

Notes

Chapter 2: Bill Ackman

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 3: Bruce Berkowitz

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 4: Warren Buffett

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 5: Ian Cumming and Joseph S. Steinberg

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 6: David Einhorn

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 7: Carl Icahn

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 8: Seth Klarman

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 9: John Paulson

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 10: Wilbur Ross

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 11: George Soros

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 12: David Swensen

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Chapter 13: Prem Watsa

Philosophy and Style

Marquee Trades

Portfolio Analysis

Notes

Part Two: Mechanical Approaches to Following the Masters

Chapter 14: Introduction

Manager Selection

Asset Allocation and Sentiment Capture

Risk Avoidance

Constructing Model Portfolios Mechanically: A Primer

Equal Allocation Largest Positions

Equal Allocation Largest New Positions

Weighted Allocation Largest Positions

Weighted Allocation Largest New Positions

10–5–2 Allocation Largest Positions

10–5–2 Allocation Largest New Positions

Notes

Chapter 15: Equal Allocation Models

Portfolio Management and Performance Analysis

Bill Ackman: Largest Three

Warren Buffett: Largest Three

David Einhorn: Largest Three

Combined Portfolio: Largest Positions

Combined Portfolio: Largest New Positions

Summary

Chapter 16: Weighted Allocation Models

Portfolio Management and Performance Analysis

Bill Ackman: Largest Three

Warren Buffett: Largest Three

David Einhorn: Largest Three

Combined Portfolio: Largest Positions

Combined Portfolio: Largest New Positions

Summary

Chapter 17: Ten-Five-Two (10–5–2) Allocation Models

Portfolio Management and Performance Analysis

Bill Ackman

Warren Buffett

David Einhorn

Summary

Chapter 18: Alternate Models

Portfolio Management and Performance Analysis

Bill Ackman: Exact Match Approximation Model

David Swensen: Asset Allocation Model

Sector Rotation Model

Simple Moving Average (SMA) Based Model

Summary

Note

Part Three: Learning from the Masters

Chapter 19: Introduction

Beating the Managers at Their Own Game

Trading Alongside the Managers

Summary

Notes

Chapter 20: Fundamental Analysis

Margin of Safety

Basic Checklist

Business Understanding

Business Sector and the Company’s Standing

Management Integrity and Competency

Valuation

Emotional Stance

Quantitative Measures

Profitability Indicators

Management Effectiveness

Liquidity Indicators

Valuation Indicators

Fair Value Estimates

Risk-Free Equivalent Fair Value

Fair Values Based on Earnings Growth

Fair Values Based on Benjamin Graham’s Teachings

Fair Values Using Present Discounted Value

Summary

Notes

Chapter 21: Types of Positions and Sizing

Diversification and Hedging

Keeping Your Powder Dry

Building and Sizing Positions

Low Probability Positions

Summary

Notes

Chapter 22: Conclusion

Ad Hoc Cloning Strategies

Mechanical Cloning Strategies

Implementing Manager Strategies

About the Author

Index

Cover Design: Michael Rutkowski

Cover Photography: ©iStockphoto.com/urbancow

Copyright © 2013 by John Wiley & Sons Singapore Pte. Ltd.

Published by John Wiley & Sons Singapore Pte. Ltd.

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To my loving parents,

K. J. Vincent and Annies Vincent,

for their inspiration and guidance

Acknowledgments

Let me begin by acknowledging the Almighty for the blessings and wonderful provisions showered upon me throughout my life. My career progression to wealth management has been no exception, for it has been a wonderful ride.

Words fail to express the tremendous gratitude I owe Nick Wallwork at John Wiley, one of the most experienced English language finance/business publishers in the world. My articles at Seeking Alpha, a premier website for actionable stock market opinion, analysis, and discussion caught Nick’s attention and he sowed the seeds for this book of strategies individual investors can implement to create alpha on their own. His insight and vision deserves credit for this maiden effort. On a related note, I salute Seeking Alpha for developing an ecosystem for investment researchers to network and develop ideas.

I have also drawn inspiration from several individuals who successfully migrated from other fields into investment management. Among them are Dr. Michael Burry, founder of Scion Capital, LLC hedge fund; Asif Suria, founder of Insider Trade Reports; Mazin Jadallah, founder of AlphaClone LLC; James Altucher, managing director of Formula Capital Hedge Fund; Mohnish Pabrai, founder of Pabrai Investment Fund; Francis Chou, president of Chou Associates Management, Inc.; and several contributors at Seeking Alpha. Their intrepid sense of going all out in fulfilling their passion immensely helped my own transformation.

I extend my sincere thanks to the hedge fund managers profiled herein for explaining their operating styles through the media over the years. That was my primary source of information for the profiles in this book.

I recognize fully the efforts of Gemma Rosey, development editor; Jules Yap, editorial executive; Stefan Skeen, senior production editor; Barbara Hanson, copy editor; and the entire Wiley team for their unwavering support throughout the development of this book.

My partner in crime and beloved wife, Shara, has been the guiding and motivating force behind me, giving encouragement at times of difficulty and setbacks. Her critical suggestions, patient understanding, and realistic expectations helped me to comprehend the bigger picture. Her passion and enthusiasm to follow a new path, along with her pleasant disposition, fascinates me. She put in a tremendous effort to edit the initial drafts of the manuscript.

While we were writing this book, our two wonderful daughters Ann Gina Konnayil and Becka Jill Konnayil held up really well in a brand new environment, despite the fact that their parents were working with a very tight schedule. For that, they deserve our special mention and admiration.

I am blessed with a lot of well-wishers, friends, and family members. I thank all of them for being there.

Preface

Managing one’s assets appropriately is indeed a monumental task. While select money managers with the elusive Midas touch easily outperform the market averages by wide margins over long periods of time, the majority of other money managers and individual investors unfortunately underperform the market averages. As these three groups—fruitful money managers, their struggling colleagues, and individual investors—represent the bulk of the market, it is evident the former gains at the expense of the latter two.

The track record of individual investors as a group has plenty of room for improvement. Equities and mutual funds are generic investment options available to all individuals, regardless of their net investable asset status. Net investable assets are the total value of an individual’s investments, excluding his or her primary residence and retirement accounts. Individuals with investable wealth of less than $100,000 are at the lower end of this spectrum, while the superwealthy, with net investable assets exceeding $10,000,000, are at the other end. An uptick in the net investable assets of an individual means better investment prospects, as the chance to wrap one’s fingers around such choice privileges as separately managed account (SMA) composites, hedge funds, private equity partnerships, venture capital, angel investment, and so on are available only to those higher up in the net investable assets ladder. The best among these exclusive opportunities manage to beat the market averages handsomely.

In order to improve the individual investor’s situation, financial gurus such as Vanguard’s John Bogle1 professed the strategy of owning index funds so that an investor can mimic the performance of the market. Eliminating the risk of underperforming the market averages is the chief benefit of such an approach. However, this relative stability has a high hidden price, the cost of which becomes apparent only when one compares the difference in the amount of money that could have been made had the investments beaten the market by a few percentage points over a long period of time.

Those money managers that are ahead of the curve make it seem all too easy to post compounded annual returns net of all fees in the vicinity of a whopping 15 percent or higher. Clearly, consistent outperformance by wide margins is not an accident, and cannot be explained away by statistical probabilities. These highly successful managers have special investment allocation skills that allow them to take their returns from ordinary to extraordinary levels over long periods of time. The wealth difference created is huge, as is shown in the following table, which summarizes returns over 30 years for a $100,000 initial investment:

A $100,000 portfolio grows to slightly over one million dollars over a period of 30 years, if investment returns come in at the long-term compounded annual market growth rate of 8 percent.

A $100,000 portfolio grows to around $1.75 million over 30 years, if investments grow at 10 percent, beating the market by a modest 2 percent. At that level of outperformance, the difference in dollar amount is over $0.75 million for the same time frame.

A $100,000 portfolio grows to a massive $6.62 million over 30 years, if investments grow at 15 percent, beating the market by 7 percent. At that level of outperformance, the difference in dollar amount hovers close to an incredible $5.62 million, that is, over 6.2 times the returns compared to the market returns.

Having recognized the striking difference in returns even moderate levels of outperformance can generate, it is only logical that an individual investor would also want to pursue strategies aimed at beating the market indexes with a high level of confidence. The seemingly straightforward way for an individual investor to partake in the performance of superstar money managers is to invest directly with them. Unfortunately, this is easier said than done! The majority of the wizards don’t accept a layperson’s money and invest on their behalf even for a reasonable fee, for a variety of reasons. The Securities and Exchange Commission (SEC) regulations aimed at protecting investors from fraud are a major deterrent. The regulations include:

Securities Act of 1933

:

2

This law governs the offer and sale of securities in the United States. Funds offering to sell securities must first register and meet either the registration requirements or an exemption. Section 4(2) of the Securities Act exempts any transactions by an issuer not involving any public offering. To qualify under this exemption, there are rules under Regulation D (504, 505, and 506, a set of requirements that govern private offerings). Many of the investment management firms rely on Rule 506 to claim such exemption. Under that rule, offerings can be made to an unlimited number of accredited investors, and up to 35 other purchasers. Also, such offerings cannot employ general solicitation or advertising to market the securities. What does it take to be an accredited investor? One way to be an accredited investor is to have a net worth of at least $1 million, alone or with a spouse. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

3

further restricted this requirement by excluding a person’s primary residence from the net worth calculation. Another way to qualify is to have income exceeding $200,000 in each of the two most recent years, or joint income with a spouse exceeding $300,000. Either of these requirements limits accessibility to the vast majority of individual investors. The regulatory curb on advertisements also makes it hard for investment management firms to reach individual investors.

Securities Exchange Act of 1934

:

4

This law governs the secondary trading of securities in the United States. The rules under Section 12(g) require that, if an investment management firm has over 500 holders of record (investors), and assets in excess of $10 million, it must be registered under the Securities Exchange Act. In their effort to avoid Securities Exchange Act registration, many investment managers try to have fewer than 500 holders of record. One way to achieve this is by having a very high minimum requirement. It is not unusual for highly successful hedge funds to have this threshold set at upward of $25 million which, needless to say, excludes a large number of individual investors.

Investment Company Act of 1940

:

5

This law regulates investment companies. It requires them to disclose material details about their financial health and also restricts certain activities, such as short selling, by mandating coverage requirements. Many funds rely on statutory exclusions under Section 3(c) that define an investment company to avoid being classified as an investment company. Section 3(c) (1) excludes issuers if the outstanding securities are owned by not more than 100 investors. Funds making use of this exclusion typically resort to very high minimum investment requirement to discourage most investors. Section 3(c) (7) excludes issuers if the outstanding securities are owned exclusively by qualified purchasers. Who are these qualified purchasers? To be a qualified purchaser, an individual investor has to own more than $5,000,000 in investments, which eliminates a high percentage of investors.

Investment Advisors Act of 1940

:

6

This regulates the activity of investment advisors. Many advisers use certain exemptions under the Dodd-Frank Act of 2010, which among other things, do not allow holding themselves out generally to the public as an investment advisor.

Moreover, many superlative money managers do not view managing individual investor accounts as their ticket to fame. Some of their typical preferred activities include the following:

Management of university endowment funds, charitable foundation trusts, and similar entities

: Some of the world’s finest money managers are engaged in managing trusts and university endowments. One of the largest such trusts is the Bill & Melinda Gates Foundation Trust, with assets over $37 billion; and leading university endowments include the likes of Harvard ($32 billion) and Yale ($22 billion). Because they employ the cream of the top money managers, it is not much of a surprise that these endowments and trusts have fantastic track records.

Family offices

:

Family offices

are establishments set up by wealthy families to manage their money. These offices typically provide auxiliary services, such as tax, estate planning, and other legal matters. Several eminent money managers have long since exited the business of investing outsiders’ money through a hedge fund to investing their own wealth through a family office structure. This trend has gained momentum recently, following the SEC adoption of a rule under Dodd-Frank Act defining family offices that are to be excluded from the Investment Advisors Act of 1940. The most high-profile conversion to date has been Soros Fund Management, the hedge fund that was run by billionaire George Soros. In July 2011, the fund decided to convert to a family office and return outside investors’ money, thereby closing the doors on them.

Management of liquid assets of large corporations

: Managing the cash assets of large corporations is a complicated undertaking that sometimes gets assigned to professional investment management gurus. Managing insurance float is a variation on this theme and, under this category, are some of the most prominent experts, such as Warren Buffett and Ian Cumming. It is possible for individual investors to own shares of the publicly traded corporations these giants represent, such as Berkshire Hathaway, Leucadia National, and so on. However, owning such shares do not provide the individual with the same benefit as would exist if his or her money was part of the pool of investments that Buffett or Cumming manages. As things stand, it is impossible for individual investors to directly participate in the money management schemes of such managers.

Private equity funds, venture capital funds, and other miscellaneous pools

: There exists an array of unregistered investment vehicles that rely on exemptions to maintain their status quo under the SEC. They are structured as limited partnerships with investors committing to fund up to a certain amount of money. Private equity funds are pools of capital that invest in illiquid securities. When the fund manager identifies an opportunity, capital calls to investors allow them to obtain funds just in time and stay fully invested. Venture capital funds are pools that invest in start-up opportunities. They are also different in that they play an active role in the management of portfolio companies and exit as soon as a good return on investment is realized. Such entities largely bypass the vast majority of individual investors, as they rely on SEC exemptions to stay unregistered.

Hedge funds and mutual funds, on the other hand, seek individual investor capital but many of them are bounded because of their need to stay outside the radar of federal regulation. Most hedge funds set the entry bar high—their minimums start at upwards of a million dollars. Hedge funds cannot be marketed like a retail mutual fund. As for mutual funds, it is very rare to find one that beat the indexes consistently over long periods of time. There are exceptions but there are the following caveats as well:

Capital gains

: Mutual funds periodically distribute realized capital gains to their investors; such distributions are taxable. Besides, mutual funds can have unrealized capital gains that will eventually be distributed. In that case, a fund can fail to fascinate as an investment option, even if it has outperformed the indexes consistently over long periods of time. Sequoia Fund is an example of a highly successful mutual fund that has outperformed the S&P 500 by around 4 percent annually over 42 years. The fund, however, has a net unrealized appreciation of the fund’s portfolio of over 40 percent of Net Asset Value (NAV), which makes it less desirable for prospective investors.

Fund closings

: Some of the best performing mutual funds are unwilling to take new investors on board. While this puts the fund beyond the reach of new investors, it is not completely out of circulation, as existing investors are generally allowed to add to their position. This is most prevalent among the best performing small cap funds, and is mostly due to the managers’ belief that increasing the size of the fund could prove detrimental to the fund’s performance. Examples of best performing mutual funds closed to new investors include the Royce Premier Fund, a small-cap–focused fund with an outstanding 20-year ∼4 percent annual outperformance of the Russell 2000 index, and the Calamos Convertible Fund with a 27 year track record of outperformance. The Sequoia Fund also fits into this list.

High minimums

: Some mutual funds also resort to high minimums to keep at bay performance chasers who move in and out of funds frequently. Consequently, the fund becomes off-limits for genuine investors, too.

An alternative to investing directly with the best money managers is to invest in a fund of funds (FoFs). FoFs are investment companies that invest in other funds instead of investing in individual securities. On a comparative basis, FoFs have relatively lower investment minimums thus making them more readily accessible to individual investors. However, many factors such as those listed below make them less desirable than investing directly with the best money managers:

Fees and performance

: FoFs add another layer of decision making between the investor and the fund managers with whom they invest. On the one hand, the funds are diversified among other funds, but the extra management layer translates to additional fees (1 percent or more, plus a performance fee is typical) being tacked on. Further, as the returns will depend on the proficiency of the fund manager as well as on the asset allocation prowess of the FoF manager, FoFs mostly lag behind the returns achieved by the top managers.

Minimum requirements

: FoFs generally do not register under the Securities Act of 1933, so they rely on the private placements route to attract assets. This results in a much smaller market reach than that which could have been attained with a retail distribution network. Consequently, FoFs target high net-worth individuals which, in turn, cause them to keep large investment minimums (upward of $25,000).

Regulation:

Although FoFs may be registered under the Investment Company Act of 1940, the underlying funds in which they invest may not be. Investors are extremely dependent on the ability of the FoF managers to do proper due diligence in the selection of fund managers with whom they invest. The magnitude of this problem was highlighted by the

7

Madoff scandal when it was disclosed that many FoFs invested with the Ponzi scheme. Such vulnerability takes the joy out of investing!

Audience

A practical and gratifying alternative to investing directly with the awe-inspiring money managers is to monitor their moves, comprehend their investment rationale, and apply their proven strategies to one’s own portfolio. Strategies to emulate the moves of remarkable money managers are the basis of this three-part book. Its purpose is to get individual investors to the next level by beating market averages with a high degree of confidence via incorporating cloning strategies in their own portfolios.

Overview

Part One begins with an explanation of the regulatory requirements that permit the public to scrutinize the investment activity of most money managers, albeit with a time delay. This section explains the simplest ways and means of cloning investment specialists individually, by inspecting their different investment styles, philosophies, and trades. An eclectic selection of 12 investment authorities is presented with particulars on:

Characteristics that distinguish their portfolios from others.

Analysis of their major moves over the years.

Discussion of their largest positions (highest percentage allocations in the portfolio) and largest additions over the years.

A peek into how selected stock picks, based on their bias (bullish, bearish, or neutral), would have performed.

The strategies put forth can be implemented into one’s portfolios without further analysis of the securities themselves. The idea is to capitalize on the legwork already done by the best money managers or, put simply, let’s not keep reinventing the wheel! Each chapter analyzes the strengths and weaknesses of the strategies to clone the moves of the best money managers one at a time, and also provides clues as to picking managers to follow.

Part Two discusses schemes that combine the moves of a selected set of money managers from Part I to construct cloned portfolios. These strategies apply rule-based criteria to the portfolios of the carefully chosen managers, so as to arrive at a list of potential securities in which to invest. The concept of model portfolios as a structured mechanical approach to follow the activities of the experts is introduced. A set of portfolio allocation models are presented with particulars on how assets can be spread among the different choices:

Equal allocation model

Weighted allocation model

Ten-five-two allocation model

Nailing down these asset allocations is not complicated. The choices are based on the source manager’s largest positions and the largest new additions. The money moves of a selected set of specialists from those introduced in Part I are used to present actual portfolios that can be constructed with this approach. Techniques to rebalance such portfolios quarterly, based on the changes made during the previous quarter, are explored. Back-tested progression spreadsheets that show how the portfolios would have performed over the years are analyzed. A description of alternatives to the long-only models is also covered:

Incorporating bond and cash allocations.

Hedging based on market sentiment.

Net long versus neutral versus short.

Cloning the asset allocation.

Chapter summaries evaluating the strengths and weaknesses of the models.

Part Three presents rules-based filtering techniques based on money manager trading activity. The concept of building money manager investment bias spreadsheets to capture their preferences is introduced. A technique to create a prioritized manager bias spreadsheet by comparing the price range the manager traded with the price when the information became public is presented. The procedure is applied to the portfolios of the selected managers to create a prioritized manager bias spreadsheet. A strategy to invest based on these bias spreadsheets is introduced. A spreadsheet showing the back-tested performance of stock picks using this procedure against the selected manager portfolios is presented and analyzed.

This section also cites two other SEC regulatory requirements that allow the investing public to scrutinize certain other types of activity in security trading:

SEC filings related to beneficial ownership of more than 5 percent in a public company, reported within 10 days of such activity.

SEC filings related to insider trading that directors, officers, or 10 percent owners are required to file within two days of such activity.

Methods to filter and prioritize security selections using information from these regulatory filings are discussed. A strategy to invest based on this information is presented. The process is applied to the filings of the selected managers to present stock picks and their performance over the holding periods recommended by the strategy.

The best money managers are known to employ several stock selection strategies. Those techniques are introduced:

Margin of safety

Buying low and selling high

Basic Q&A checklist

Quantitative checklist

Fair value estimates (FVE)

The importance of having different types of positions that are optimally sized is covered:

Low probability versus high probability bets

Positions that correlate inversely with the overall market

Market neutral positions

Keeping your powder dry

Right sizing positions

The final chapter pulls everything together, with a discussion on the relative strengths and weaknesses of the different approaches proposed throughout the book.

Notes

1. John C. Bogle, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Hoboken, NJ: John Wiley & Sons, 2007).

2. Securities Act of 1933, May 27, 1933.

3. Dodd-Frank Wall Street Reform and Consumer Protection Act, January 05, 2010.

4. Securities Exchange Act of 1934, June 6, 1934.

5. Investment Company Act of 1940, August 22, 1940.

6. Investment Advisors Act of 1940, Aug. 22, 1940.

7. Bernard Madoff, former non-executive chairman of the NASDAQ stock market, and the confessed operator of a Ponzi scheme.

PART ONE

TRACKING 12 OF THE GREATEST MONEY MANAGERS

Chapter 1

Introduction

Investors are spoiled for choices when it comes to investment styles. There is no consensus on style even among the greatest money managers. Choosing of money managers to shadow requires careful consideration, as not all investment styles are conducive to cloning. Classifying money managers by their style is a practical initial step. This can be confusing, for many managers do not adhere solely to one style. Listed here are the most popular investment styles. Though they are often interchangeable, there are some differences among them:

Directional

: Directional managers forecast the turn of individual securities, as well as that of the overall market, based on analysis. Regardless of the type of analysis, the underlying theme is that the strategies they employ (long/short, managed futures, global macro, and dedicated shorts) rely on the outcome of the study to make a buy/sell decision. The long/short strategy, a favorite among money managers, is when directional bets are made both on the long and the short side. Global macro strategy banks on the analysis of the macroeconomic developments of the world to make investment decisions. Managed futures tactics depend on commodity trading advisors (CTAs) taking futures contracts and options positions based on fundamental or technical analysis.

Event driven

: Event-driven managers are on the prowl to profit from some expected event, the effect of which is yet to be factored into the market. Events they are drawn to include turnarounds in distressed securities, including securities undergoing bankruptcies, changes to the management structure and/or operation made possible by shareholder activism often spearheaded by the manager, and so on. In risk arbitrage, the play is on the risk that a closure or breakup of an announced merger or spinoff deal will not happen, thereby realizing the risk premium as profits, when the deal closes.

Market neutral

: This is a nondirectional absolute-return strategy used by money managers who seek to earn profits regardless of the route the market/sector they invest in takes: up, down, or sideways. A common way to achieve this is by using a variation of the long/short model. Here, the manager simultaneously builds a 50 percent long position in certain securities and a 50 percent short position in other securities in the same market/sector. If the manager’s stock selection skill can return 10 percent annualized (both on the long and short side), then, independent of the direction in which the market/sector moved, the portfolio would return 10 percent. For example, assume a manager invested $100,000 using this model ($50,000 long and $50,000 short), and that the market/sector went down 40 percent during the period. The long portion of the portfolio will return −30 percent (−40 percent mirroring the market and +10 percent from the manager’s superior stock selection skills). In dollars, the investment of $50,000 on the long side has shriveled to $35,000. The short portion of the portfolio on the other hand will return +50 percent (+40 percent countering the market and +10 percent from the manager’s ability to achieve 10 percent annualized return). The $50,000 invested in the short side has swelled to $75,000. The total portfolio will then show a value of $110,000 or a 10 percent return. Other market-neutral strategies include

pairs trading

and

delta neutral trading.

In pairs trading, the manager is on the lookout for perfectly correlated securities to develop a temporary period of divergence. When a match is found, the positions are offset (short the outperforming security and long the underperforming one) to take advantage of the price discrepancy. In delta trading, securities and their related options are combined to create a composite position whose delta is zero (

zero delta

means there is no correlation to the underlying security involved).

Quants

: Quant funds utilize computer-based models that depend on quantitative analysis to come up with buy/sell decisions on the securities they invest in. The level of automation varies between funds: Some funds analyze and execute trades automatically using such models while in certain others the final investment decision to buy or sell a security rests with the human analyst, although the computer model provides the choices. There are also combination funds in which some trades are executed automatically while others require human input. The best quant funds include Renaissance Technologies, D. E. Shaw & Company, and AQR Capital Management, and sport long-term return percentages well into the teens.

Risk optimized

: This is a multi-asset class investment strategy. It applies an asset-allocation-model that combines noncorrelated relatively risky assets and builds diversified portfolios that are less risky overall but still contain a high expected return characteristic. The idea is based on the Nobel-Prize–winning modern portfolio theory (MPT), which formalized the concept of diversification in investing and on the capital asset pricing model (CAPM), which introduced the idea of factoring in an asset’s nondiversifiable systematic risk (market risk) and the expected return when adding an asset to a portfolio.

Others

: Managers that do not fit well into any of the preceding investment styles may be classified by the type of securities or the sectors they focus on: value versus growth, small cap versus midcap versus large cap, developed versus emerging markets, domestic versus international versus foreign, etc.

Directional style can be readily cloned. Regardless of the directional style used, the positions are based on some analysis that triggered the manager to place a directional bet on a security. To duplicate, include one or more of the manager’s positions in one’s own portfolio. Event-driven styles are also easily emulated, although individual investors will have trouble replicating some of the moves. While it is not complicated to imitate a position that an event driven manager establishes in a public company, many event-driven managers focus on distressed securities that are not traded, thereby cordoning off such positions from individual investors. Some strategies of market neutral style can be cloned effectively. The long/short variant strategy is relatively simple to replicate in aggregate. To achieve this, identify the positions and ratios involved, and allocate cash similarly in one’s own portfolio. On the other hand, pairs trading and delta trading are tricky. In pairs trading, the window of opportunity is so tiny that only those who are ahead profit. Followers can wind up being too late. In delta neutral, the positions that combine to achieve a zero delta are complex and may not be apparent to an outsider. Quant funds are best left alone largely due to the sheer volume of trades executed during a quarter. Risk optimized style may be simulated as long as market-traded securities are used. To follow the strategy, the whole portfolio is cloned.

13Fs: A Window into Hedge Fund Activity

Being privy to the moves of money managers is critical for effective cloning. The regulatory requirement of SEC Form 13F is helpful to a point in this regard. It insists that institutional investment managers with investment discretion of $100 million or more in qualifying securities file this form. This rather broad rule applies no matter whether the investment management firm concerned is registered as an investment advisor per the Investment Advisors Act. As such, almost all money managers have to file Form 13F. Every quarter, the SEC publishes the list of qualifying securities; the latest list has around 16,000 entries comprising of the shares of stocks listed in NYSE, AMEX, and NASDAQ, and closed and open-ended investment companies.1 For each stock listed, related instruments such as call-and-put options, warrants, and so on, are also included. Investment managers have to report details on the number of securities owned, the market value of the securities as of the end of the quarter for which the report is filed, etc. 13F filings, however, have several limitations:

Timeliness is not a virtue of 13F. The information is due only within 45 days from the end of every quarter, making the buy/sell activity derivable from the reports inherently late by at least 45 days. To put it in perspective, if the buy/sell activity was executed on the first day of a particular quarter, this data might be four and a half months old! This essentially renders cloning useless, if the strategy of the money manager was time sensitive.

The 13F does not provide a complete reflection of a manager’s moves as only long holdings in the U.S. markets are reported in it. Many of the best money managers invest globally in all kinds of securities and the U.S. listed long selection is only part of their overall portfolio. The 13F contains information only on this subset. It does not shed light on the key elements of the manager’s asset allocation strategy such as bonds, cash, and other alternative investments. These limitations severely undermine cloning money managers focused on alternate investment strategies, such as dedicated short, and income focused, as well as money managers who prefer investing outside the United States.

Investment managers can request confidential treatment of 13F trades and delay reporting up to one year.

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The majority of such requests are rejected, as the onus is on the investment management company to establish that absence of such immunity would impede their competitive position. Even so, the filing company still scores, as they can delay disclosing the position until the SEC rejection letter is received.

Currently, all 13F filings are in text format and are accessible to the public via the EDGAR (Electronic Data-Gathering, Analysis, and Retrieval) system. An SEC review (September 2010) of the Section 13F reporting requirements recommended plugging loopholes and rectifying limitations. Among them are the timely handling of confidential treatment requests and enforcing the requirement to supply background documentation.3 The review also recommended looking into expanding the definition of 13F securities, among other things. They observed that not only did the current text format used in 13F filings make it very difficult to analyze and manipulate the data submitted, but that there was also lack of uniformity in reporting. The recommendation calls for a more structured format, such as Extensible Markup Language (XML). Once the recommendations are implemented, the system will become much more user friendly. Until then, those wanting to study the moves of money managers have to work around such limitations.

Filtering 13Fs for Relevant Activity

The information in the 13F filings in text format carries all the details of a fund manager’s long positions. It is easier if the numbers are analyzed using a spreadsheet. Table 1.1 is one such spreadsheet, with the details of Mohnish Pabrai’s (a California hedge fund manager) U.S. long holdings as of Q1 2012, derived from his corresponding 13F filing.

Table 1.1 Mohnish Pabrai’s U.S. Holdings: Q1 2012

From this spreadsheet, the following valuable information about Pabrai’s portfolio can be gleaned:

Mohnish Pabrai is running a very concentrated portfolio with just eight positions.

The total value of the holdings is $324.75 million.

Pabrai’s largest three holdings are Bank of America (BAC), Citigroup (C), and Goldman Sachs (GS). Combined (∼62 percent of the total portfolio), they make for a huge bet on financials. The percentage is obtained by adding the corresponding figures in the Market Value column and dividing by the total value of the holdings.

The spreadsheet, however, lacks the comparative information that provides insight into the manager’s investment bias during the quarter:

What are the largest buys in the quarter?

What are the largest sells in the quarter?

What positions were newly added in the quarter?

What positions were eliminated in the quarter?

How does the portfolio compare to that of the previous quarter?

This information can be visualized by incorporating information from 13F filings of previous quarters. Table 1.2 is a spreadsheet with details of Pabrai’s U.S. long portfolio holdings from Q4 2011 and Q1 2012. It succeeds in answering the comparative questions raised earlier:

Table 1.2 Mohnish Pabrai’s U.S. Holdings: Q1 2012 and Q4 2011

Bank of America (BAC), Citigroup (C), and Goldman Sachs (GS) are the three largest buys during Q1 2012; compare the market values for 12/31/2011 with the corresponding market values for 3/31/2012. The biggest increases indicate the leading buys.

Berkshire Hathaway (BRK.B), Wells Fargo (WFC), and DIRECTV (DTV) experienced the three largest stake reductions during Q1 2012; compare the market values for 12/31/2011 with the corresponding market values for 3/31/2012. The largest decreases denote the main stake reductions.

No new positions were added in Q1 2012; absence of rows with entries for 3/31/2012 (market value and number of shares) with corresponding empty columns for 12/31/2011 indicates this.

Berkshire Hathaway (BRK.B), Brookfield Residential Properties, Cresud (CRESY), DIRECTV (DTV), and Wells Fargo (WFC) are the positions eliminated in Q1 2012; the presence of rows with entries for 12/31/2011 (market value and number of shares) with corresponding empty columns for 3/31/2012 indicates this.

The portfolio size increased by ∼38 percent during the quarter, and it has become even more concentrated than in the previous quarter.

Historical holdings information can be studied by adding more columns from the 13F filings from the previous quarters into the spreadsheet.

Raw 13F Filings from EDGAR

Table 1.3 is a snapshot of the Information Table section of a raw 13F filing downloaded from SEC’s online EDGAR search system.4 (Pabrai’s filing for Q1 2012). To download and view 13Fs from the EDGAR search system, enter the name of the investment firm the manager represents (for Pabrai, use Dalal Street for filings from Q1 2012 onward, or Pabrai Mohnish for previous ones), select Exclude in the “and Ownership Forms 3, 4, and 5” field, leaving other fields blank, and use the Find Companies button. If the search criterion results in a unique match, a list of filings from the firm is returned. Otherwise, a selection must be made from a list of matching investment management firms. The end result is a list of filings from the selected investment management firm. Download and view the filing required by using the Documents button for the corresponding 13F-HR for the date concerned. The filings are done within 45 days of the end of quarter; for a Q1 2012 filing, search for a 13F-HR row with a date around May 15, 2012.

Table 1.3 Snapshot of Pabrai’s Q1 2012 13F Filing

Pabrai has a very straightforward 13F filing. The raw filing has eight columns and the information from columns 1, 4, and 5 are used to populate the spreadsheets presented earlier. As indicated by the column 4 title, the column value must be multiplied by 1,000 to get the dollar figures in each of its cells. The remaining transformation is a straight one-to-one copy. To cross-check, compare the total value in column 4 with Form 13F Information Table Value Total field (further up in the filing report).

Many 13F filings have additional information in the other columns. Table 1.4