Sunday, May 8, 2011

Secrets of Elite Funds - Brief Intro

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.

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