Imagine you're at a poker table, surrounded by some of the world's greatest professional players. They've read every poker book, played thousands of games, and seen virtually every hand: The odds are clearly in their favor. You must decide whether to play, knowing the competition is fierce, or walk away.
Investing in the stock market is not entirely different. Your competition includes the brightest investment minds in the world. You can play your own hand and make decisions on whether to trade shares of say Apple or Coca-Cola, or you can simply purchase an inexpensive index fund that tracks the market.
Fortunately for investors, there is a third alternative: to track what world class investors are buying. Regulators require all investors with over $100 million in U.S. listed stocks to reveal their hand on a quarterly basis in a filing called Form 13F. These filings offer a window into some of the market's best minds, such as Warren Buffett and David Einhorn.
Some observers have been quick to dismiss investment strategies that use 13F information. This is because 13Fs are filed with a 45-day delay and only show long stock positions of hedge fund managers, leaving out shorts, options, and swaps. Ignoring either of these limitations would be a grave error.
But when used correctly, the information is extremely valuable. With thousands of 13Fs filed each quarter and dozens of stocks listed on each form, the key question becomes, '"How can this information be used most effectively?" The devil is in the details, but the high level concepts are surprisingly straight forward.
It's critical to pinpoint funds with lower turnover ratios, thereby limiting the impact of the 45-day delay. Analyzing these forms doesn't require a lot of guesswork. They clearly identify the manager and their long stock portfolios throughout consecutive quarters, which reveals how often the holdings are changed. Some of the best investors, such as Buffett's Berkshire Hathaway, turn their portfolio over a lot less than people assume, and publicly available information clearly identifies who they are.
Two additional crucial factors to account for in 13F tracking are the overall size of the portfolio, and size of the position.
In a co-authored paper by professors at York, Seoul National and Rutgers universities, researchers found that there is a statistically significant positive relationship for securities held by large hedge funds but not for those held by small hedge funds. The authors rationalized that "the return forecasting power of hedge funds is stronger when they possess more resources and hence have better access to expertise and talent." In other words, tracking the largest funds creates a more accurate picture of true alpha generators.
In a separate paper from Harvard Business School, London School of Economics and Goldman Sachs, researchers attempted to quantify the outperformance of a manager's "highest conviction picks," or stocks with the highest overweighting in a portfolio. After controlling for many factors, including market premium, momentum, size, growth, riskiness and short-term price reversion, the authors found that the "best ideas" portfolio generated excess returns of 0.82 percent per month. When they narrowed the index to include only the top 5 percent highest conviction picks, the alpha increased to 1.01 percent per month. The highest conviction picks among fund managers had proved to also be the best performing.
Utilizing 13F filings as a wellspring for alpha-like returns is no easy feat, and missteps are easy to make. At the same time, it would be a mistake to throw the baby out with the bathwater. A discerning investor looking for alpha will find that publicly available information can help construct a successful portfolio. In fact, it may be the closest way to long-only equity hedge fund returns without the fees.
