The Copycat World of Hedge Funds

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.