Why following hedge funds is a sucker's game

by Michael Tarsala
Artwork by: jelene

by Michael Tarsala

I never understood the press obsession with hedge fund disclosures -- the filings that tell you the stocks that David Einhorn, Steven Cohen and their peers bought and sold.

They could have long since cashed out by the time there's an SEC report detailing what they purchased.

And now we know they are hiding their best asset purchases with the SEC's help.

About a third. That's how much as a percentage of portfolio value hedge funds obscure from the public, and all with the SEC's blessing, according to a new paper by researchers at the University of Cologne, Columbia and Georgia State.

Those so-called confidential filings are legally omitted from the From 13F reporting process and are allowed to be updated many months later in some cases with a form amendment.

Why so many secrets?

It’s the confidential holdings that tend to have superior performance, the research suggests. And the hedgies don't want you following their best trades and investments.

For that matter, the SEC doesn't either.

The SEC justifies hiding what hedge funds are doing as protecting the public interest. And as with most anything, there is a kernel of truth there. Without confidentiality, certain market moves could in theory reveal the investment strategy and harm the competitive position of hedge funds. And if the strategy of Steve Cohen was known for instance, volatility in the stocks he’s buying could go haywire.

Confidential filings do not even make headlines all that often. The last splash was in November 2011, when Berkshire Hathaway finally revealed its $10.7 billion ownership stake in IBM, a position it accumulated secretly with the SEC's help over a period of two quarters.

But as the research paper details, confidential treatment happens all the time.

Keep in mind that of the two-thirds of positions we do see, the moves of hedge funds are made public as much as 45 days after the end of the quarter in which they were actually made. So in some cases that's as much as 19 weeks after a position was taken.

That seems like a hell of a long time to me.

And it’s why following the hedge fund positions that you do see simply does not work.

You would lose about 10% a year if you bought the same stocks that mutual funds and hedge funds did as soon as they disclosed their holdings, according to Thomson Reuters research.

So in light of the latest academic research, I have four remaining questions:

  • How the heck is a GURU ETF going to pan out?
  • Do hedge funds even need confidentiality given the massive delay already baked into the reporting process?
  • Knowing what they do, why does mainstream media still go gaga over 13F filings?
  • And why should any investor even pay attention?

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  • http://www.tradestreaming.com Tradestreaming

    Hi Michael,
    I really enjoy reading your posts but 'm going to have call BS on this one. Like anything worthwhile in investing (in life, actually), you need to start with a plan.

    I agree with you that aberrant fascination with 13Fs and just buying them all willy-nilly is a bad idea. But so is buying something that Cramer said.

    There is clear evidence that building strategy-driven portfolios that cherrypick some of the best picks coming out of the hedge fund world works. Hedge fund managers are the new celebrities in the investing game, much like mutual fund managers were in the 80s and 90s. 

    13fs are certainly a form of financial voyeurism but used correctly, can be the building blocks of sound, outperforming portfolios.

  • Mike Tarsala

    Thanks for reading.

    My main concern is that there is now a cottage industry tracking 13Fs. I would say most of those services lack anything close to plan. The mainstream media certainly does not have one. They mainly use 13Fs as a proxy for interviews with celebrity managers.

    You should read this post, which is to your point about strategy-driven portfolios:
    http://blog.covestor.com/2012/03/speed-a-potential-key-to-follow-the-leader-investing
     

    A few services can identify stocks that tend to be attractive to hedge fund managers/professional investors. One is StarMine Professional. But it's expensive, and sold only to market professionals.

    Validea is a good service. But as you may know, the performance cited is not from actual trading, and doesn't include fees.

    Alphaclone is also one you may know, but I have not seen the actual performance of the models there -- only the backtested performance.