Secrets of Elite Funds - Brief Intro

Leo Kolivakis's picture

Via Pension Pulse.

What a beautiful day it was in Montreal. Absolutely perfect weather to
celebrate Mother's Day. I wish all the moms out there a Happy Mother's
Day, especially my mother who I love a lot. The only problem is that I
was out all day enjoying this weather and I'm tired as I hit the gym
early today.

Before I delve into this topic, please go back to read my comment on the value of losing money.
If you've never felt the exhilaration of making money and more
importantly, the pain of losing money in the markets, then you are not
ready to manage money, especially not your own money. Most people
shouldn't be managing their money which is why I wrote a comment on the big secret
stating that most investors are better off investing in some small cap
value ETF and rebalancing their stock/bond portfolio at least once a
year or as needed.

But I'm reminded of the wise words of Paul
Samuelson who once remarked that if everyone adopts Burton Malkiel's
"random walk" approach and invests in ETFs, even small cap value ETFs,
then the collective actions of many will influence future returns. I
mention this because legendary fund manager Jeremy Grantham, chairman of
fund shop GMO and one of the few people who successfully called the
2008 crash in advance, is warning investors that small cap stocks are overvalued:

His
firm’s latest calculations predict that investors in U.S. small-cap
stocks will actually lose about a fifth of their money in real terms
over the next seven or so years. That’s an annualized loss of about
2.8% after inflation.

 

As always when it comes to predictions, there are no guarantees. But GMO’s forecasts have a good track record.

The
article cites many reasons as to why small cap stocks are overvalued,
including QE2 and the fact that investors believe small caps outperform
over the long-run (with greater volatility), but let me tell you the
real reason why small caps are rising so much. Go back to read my
comment on whether hedge funds have grown too big. With so much money being shoveled to hedge funds, it's not surprising to see small cap stocks rally so strongly.

Why
is that? For one, a large percentage of hedge fund investments go to
Long/Short Equity funds. The strategy of these funds is very similar.
They go long small cap stocks which are not covered properly by analysts
and go short large cap stocks which are more liquid and covered to
death by analysts. I wouldn't be surprised if many hedge funds are just
swapping into a small cap index for their long position.

I believe
in tracking the activity of elite funds closely. In particular, I track
quarterly holdings of a number of elite hedge funds and long-only
funds, many of which I mentioned in the past when I wrote about why small is beautiful.
Why do I track quarterly holdings of elite funds? Simply because the
best funds attract the best talent (they can pay them top dollar) and
they typically exhibit performance persistence over a long period.
You're not going to get a thousand elite funds. Only the cream of the
crop can truly boast of long-term success.

The question I often
get is do I just mimic what these top funds are doing? I don't mimic
anyone and will choose my entry and exit very carefully. The quarterly
holdings of top funds helps me focus, especially if I notice a cluster
of activity in a certain stock or sector. Institutional investors
investing in top funds should be asking them their top 10 long and short
positions every month and the reasons behind these positions.

I
screen stocks daily, looking at largest percentage moves (up and down),
moves on unusual volume, and then I add them to a list of stocks that I
filter by industry. This allows me to see if the stocks are moving in
unison (beta) or if it's company specific news moving one stock up or
down.

There are always news stories covering some elite hedge fund. For example, Marketwatch reports that Greenlight Capital is betting on a possible initial public offering by auto-parts maker Delphi Automotive. Minyanville reports that Einhorn’s quarterly letter
to investors in his funds discussed establishment of new positions in
Internet-giant Yahoo (YHOO) and electronics retailer Best Buy (BBY).
This is the type of information I look for to do my own analysis,
paying close attention to whether other elite funds are also initiating
or accumulating more shares of certain companies.

It sounds
easy but it's far from easy. Quite often stocks that are being bought by
top funds are also heavily shorted or heavily manipulated by other
funds. You might see great earning reports, one after the other, and yet
the stock keeps falling, leaving you bewildered. Trading stocks,
especially day or swing trading stocks, is not an easy game. I've done
it before, and will do it again if I have to, but it's very tough to
consistently make money. You need to have discipline, cut your losses,
and know that things can get very volatile (tight stop losses can work
against you).

I'm running out of gas so I will come back to this
topic next weekend, providing you with more analysis of what top funds are
actually buying and selling. If you love picking stocks, this is going
to be a treat for you.