You can beat the market following hedge funds’ 13F filings, and we’ll show you how.
In the article, Taub breaks his argument into three parts; we will deconstruct each.
Taub’s First Argument: Hedge funds’ most popular stocks performed terribly since September. This means that it’s not always a good idea to mimic their top picks.
In his analysis, Taub mentions that “the hedge fund set is not always so brilliant,” adding that “three of the four most widely held stocks lost money from October through December.” These are Apple Inc. (NASDAQ:AAPL) (-20.2%), Google Inc (NASDAQ:GOOG) (-6.3%), and Microsoft Corporation (NASDAQ:MSFT) (-10.3%).
He’s wrong because: You can always find a time period where any investment strategy underperforms.
It’s no secret that some of tech’s biggest names have been struggling over the past few months; you’d have to be living under a rock to miss daily news of Apple’s fall from above the $700 mark. But let’s be clear: any investor owning this trio of stocks for the entirety of 2012 would have come out in the green. Apple returned over 30%, Google was up 9.5%, and Microsoft gained 2.9%.
Our main point, though, is that in order to test any investment strategy, an actual empirical analysis must be done, and the time period must be much larger than simply three months. We did one, and the results speak for themselves.
We have 10 years of 13F data for 92% of all hedge funds between 1999 and 2009. The 30 most popular picks among hedge funds generated a positive alpha of 10 basis points per month (see the details here). This means that on a risk-adjusted basis, hedge funds’ most popular stock picks outperformed the market by around 1 percentage point per year over the 10 years we analyzed.
Taub’s Second Argument: There is a 45-day delay in reporting, and hedge funds’ portfolios might change significantly. He assumes that you cannot beat the market because of this delay. He also assumes that you cannot replicate hedge funds because of this delay.
He’s wrong because: This delay actually helps investors’ ability to beat the market by imitating hedge funds.
Once again, there’s no shred of empirical evidence behind Taub’s argument. He makes the assumption that hedge funds are great at timing the market, and if you imitate their 13F holdings with a 45-day delay, you’ll get burned.
This isn’t true.
In fact, hedge fund managers can’t always perfectly time the market. If they’re early into an investment, then imitating them after a 45-day delay might yield even better results. We can prove that this is the case.
In our original analysis, we also used a 2-month delay in our backtest of hedge funds’ 30 most popular picks. We found that between 1999 and 2009, these most popular stocks generated a monthly alpha of 19 basis points (more than 2 percentage points per year). Our results got even better.
Above, when we imitated hedge funds with no delay, we generated an alpha of 10 basis points per month; in practice this isn’t possible. With a 2-month delay, we improved our performance over hedge funds by 1 percentage point. We beat hedge funds by 1 percentage point per year, and the market by 2 percentage points.
So, both of Stephen Taub’s assumptions are wrong. It is a good thing for monkeys to have to wait 45 days to see hedge funds’ portfolios.
What’s the lesson here folks?
Always test your theories using actual data. Stephen Taub’s assumption that it’s preferable to imitate hedge funds’ picks in real-time is grossly misguided.
If we can outperform hedge funds by imitating their positions with a 2-month delay, this proves that they are early in timing the market, and it is better for investors to imitate them two months after the fact.
Taub’s Third Argument: Hedge funds use exception rules and hide some of their positions for a certain period of time, sometimes even longer than 45 days. He assumes that this delay makes these stock picks worthless.
He’s wrong because: We used all filings (including those that disclose positions several months late) and found positive alpha.
The assertion that exception rules somehow prevent some of hedge funds’ stock picks from being discovered until it’s too late is incorrect. Our analysis shows that even with this longer delay, it’s still possible for 13F mimickers to generate a positive alpha.
With that being said, we’d be happy to compare our empirical results with those of Stephen Taub, but sadly, we were unable to find any actual data in his corner.
Taub’s Conclusion: Don’t treat 13F filings as a valuable tool that will enable you to invest like the smart money.
He’s wrong because: Stephen Taub doesn’t have any data to back up his claims. Our research showed that imitating hedge funds’ most popular stock picks generated a monthly alpha of 19 basis points. But that’s not the whole story.
Investors that imitate hedge funds’ most popular small-cap stock picks increase their chances of beating the market significantly. On the whole, hedge funds generate significantly higher alpha in the small-cap space. There are fewer analysts covering the little guys, and these stocks are less efficiently priced. Therefore, hedge funds spend enormous resources to analyze and uncover data about these stocks, and it’s one of the best places to generate stellar outperformance.
We recently started sharing our best strategies in our quarterly newsletter. Since going online, our small-cap strategy has beaten the SPY by 12.2 percentage points over the past four months.
While our track record is shorter than most, our bevy of backtests prove that this strategy works; between 1999 and 2009, the 15 most popular small-cap stocks among hedge funds managed to beat the market by 1.4 percentage points per month.
Our small-cap strategy’s alpha was 1.2 percentage points per month over this time period.
How can you capitalize on this strategy?
Check out our latest quarterly newsletter in our Premium section, and try it free for 30 days.
