In the world of bookmaking,
there always has to be one bookmaking firm that comes out first with the odds
on a particular event. Once the odds are visible to other bookmakers, they will
invariably copy them, safe in the knowledge that a fair degree of skill went
into the formulation of the odds by those leading the field. In fact, taken to
its extreme, you don’t actually need any skills as a bookmaker if you are able
to quickly copy and adjust your odds based on what your skilled
competitors are doing.
Another analogy, when I was
in high school, I had two classmates (in mathematics) named Jeff and Peter (not
their real names). They were both friends. Jeff was very smart (he went on to
become a doctor). Paul wasn’t so bright. For about half a year, Jeff allowed
Peter to discretely copy his answers in tests. Jeff got As, Peter got Bs. The
teacher eventually woke up to what was going on and separated Jeff and Peter.
After this, Jeff continued to get As and Peter got Ds.
Now the world of hedge fund
investing is exactly the same as the bookmaking scenario and the story of Jeff
and Peter. Of the thousands of funds out there, very few are truly skilled.
This is why there is a huge industry in “copycat” funds.
The general partner of a
copycat fund has no real skill as an investor, but like the fast moving (but
unskilled) copycat bookmaker, he (it’s almost always a he), can scour SEC
filings to determine what his much more skilled competitors are doing.* Once he
sees that the highly skilled Baupost Group (for example) has just established a
major long position in BP Plc, he can simply copy it. He might have read that
the famed Carl Icahn has been accumulating Apple stock and he may join in too.
Or he may have perused Greenlight Capital’s recent letter and read about its
position in Micron Technology and decided to copy it.
There is nothing wrong with
you as a private investor copying the great investors of this world. But if you
are managing money on behalf of others and taking a cut of the profits and all
you do is copy, then you are running a sham organisation.
As Nassim Taleb has pointed
out, in most professions, if someone is no good at it, it will be obvious.
Imagine an incompetent chef, or dentist, or plumber. Their incompetence will be
quickly seen. However, this is not the case in money management. The
incompetence will eventually become apparent, but it may take years, and in
that time the charlatanic fund manager can make himself a multi-millionaire**.
The skilled hedge fund
managers actually love the copycats. They love them because their buying pushes
prices higher and this means that their disclosed long positions are getting a free
boost. (This is why some successful hedge fund managers will kindly tell you in
their investor letters exactly what they are purchasing [and why] and what
price they purchased at and then make sure the letter becomes available
online).
I was more than a little
amused when I noticed some time ago that an Australian based hedge fund had suddenly
disclosed a position in an obscure US company. I knew immediately that they had
simply copied it from a very prominent US hedge fund. They could not have
possibly known about this company prior to the US fund disclosing its stake
(and helpfully providing its investment thesis).
Of course the problems with
copying are that you will almost always buy at a worse price than the fund you
are copying, further, you don’t know what the fund is doing between SEC filings
and you also don’t have any knowledge of short positions (i.e. is the long
position a hedge for an undisclosed short position?). Also, if you are not very
selective in whom you copy, you can potentially be suckered into copying an
unskilled manager – the ultimate sin.
Personally, I don’t often
copy others (although I have done it at times, with mixed results). It can be
fraught with danger and it’s also very hard to deal with the inevitable losses
that come with copying when the idea was never yours to begin with! I have
found time and time again that the best ideas are always my own, sounds
arrogant, but it’s true.
I basically think about my
own investing as a private hedge fund, in the sense that I’m the only investor.
I can pretty much do most (but obviously not all) of what a major hedge fund
located in New York, Greenwich (Connecticut) or London could do, but I do it
all from the peace and quiet of my home office and have no one to answer to.
The take home message is, don’t
waste your money investing with copycats. Why invest with Peter when you can go
with Jeff?
* I
refer to SEC filings as the US is home to almost all of the best investors. I
wouldn’t waste time trying to copy any of our high profile Australian fund
managers.
** Thanks
to Nassim Taleb for the word “charlatanic”. I’ve not seen it used anywhere
outside of his book – The Black Swan.
