The Big Secret?

Morgan Korn at Yahoo's Breakout reports, Superstar Managers Don’t Mean Superstar Returns: Renowned Investor:

Renowned investor Joel Greenblatt can't keep a secret.

The founder of Gotham Capital, the hedge fund he started in 1985 that produced 40 percent annualized returns under his 20-year tutelage, wants you to be rich. Very rich. And it doesn't mean pouring your hard-earned money into five-star rated funds or hiring talking head money managers (they are plenty of them on cable business channels). In Mr. Greenblatt's latest book, The Big Secret for the Small Investor, he decodes the secrets of Wall Street for the average investor and debunks the most common myths of investing.

What's the biggest secret revealed? "Investing comes down to valuing something and paying a big discount to that value," Greenblatt recently told Breakout. In his book, Greenblatt gives plenty of examples of how to determine a company's valuation with simplified numbers and mathematical equations. He strips away the grandeur and lays bare the basics of investing. Greenblatt says investors should look for a basket of companies that appear undervalued, because winning big in the stock market means "figuring out what something is worth and paying a lot less." Of course, determining a company's value and future earnings can be very difficult, even for the most sophisticated and experienced money managers, Greenblatt admits.

Another secret Greenblatt divulges is that market-cap weighed indexes beat most active managers —- and all successful managers go through periods of underperformance. Therefore, investors should avoid chasing managers based on prior performance stats -- as we know, past performance does not guarantee future success. Historically speaking, Greenblatt said 70 percent of active managers have underperformed the market over the past 10 years and "odds are investors are not going to find that superstar manager." Believe it or not, retail investors and money managers really do compete on an equal playing field, he adds. The market is "very emotional," and to separate the emotion from the reward, Greenblatt recommends buying ETFs —- specifically Value Index ETFs.

Follow Greenblatt's advice and your portfolio could soon be well ahead of the markets and outperforming even the most eminent managers. Warren Buffett and Ben Graham made fortunes looking for value, and so can you.

You can watch the interview below. Let me comment on Mr. Greenblatt's advice. Fist, I agree with him but with a qualifier (see below). The overwhelming majority of active managers underperform the market, especially after fees, so small investors are better off buying Value Index ETFs. In fact, some argue that large investors, like pension funds, are better off investing in a Fundamental Index instead of the traditional cap weighted index.

Go back to read my conversations with AIMCo's Leo de Bever on when the music stops and with OTPP's Neil Petroff on active management. Mr. de Bever discusses how he cut external manager fees considerably and moved assets internally to control costs and Mr. Petroff discusses the advantage that pension funds have over mutual funds which typically churn their entire portfolio every 12 to 18 months. Importantly, pension funds' longer time horizon allows them to be patient enough to ride out any short-term volatility and realize huge gains if they invest at the right time.

Now, let me share with you another secret, one that Mr. Greenblatt doesn't discuss. There are elite asset managers who have stellar long-term track records. I'm not just talking about some elite hedge funds, like Citadel, but other top long-only managers like Dodge & Cox Funds. I track the quarterly filings of roughly 50 top funds very closely, paying close attention to which positions they're increasing considerably, which positions they're cutting, and what are their new holdings. For me, this is all information that I use when analyzing markets.

I'm very careful not to read too much into quarterly filings because some hedge funds churn their entire portfolio every quarter, but that's why I also look at more long-term funds that look at holding positions for a longer period. I like seeing a bunch of elite funds buying the same stock at the same time, and then I put it on my watch list, paying close attention to technical and fundamental trends.

In my personal portfolio, I prefer taking concentrated bets on a few stocks than investing in any ETF, but if I were to give advice to the majority of small investors, I'd say stick with what Mr. Greenblatt is recommending and invest in Value Index ETFs. Most Long/Short hedge funds are long small cap value stocks and short large cap stocks. Most of these hedge funds underperform the small cap value index over a long period. So why pay 2 & 20 for mediocre results?

If you want to know where the elite hedge funds and asset managers are investing in, I am willing to share this information, but it's not going to be free. And just knowing where they're investing isn't enough. You have to also know whether they're manipulating certain stocks/sectors and how to beat the high-frequency trading platforms which are wreaking havoc in these markets. Knowing when to buy is crucial, especially for long-term investors.

Finally, I wish you all a Happy Easter.