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.

 

Berkshire Revisited

Back in May 2011 I wrote an article on this blog making the case that Berkshire Hathaway was looking cheap (Click here to see the article or go to my May 2011 folder). At the time Berkshire A shares were trading at around $120,000 and the B shares were approximately $80.

I reasoned that Berkshire looked cheap because the price-to-book value was at a historically low level (1.24). I then assumed a more realistic ratio of 1.44 and estimated an 8 percent growth in book value per share to the end of 2013 (the logic for those figures were explained in the original article).

By doing that, I arrived at a forecast year-end 2013 price of $173,000 for the A shares and $115 for the B shares.

So how did I go? Berkshire A shares as of 27 November closed at $174,625 per share and the B shares closed at $116.58.

It just goes to show that it doesn’t always take rocket science to spot a good investment opportunity.

I also added back in May 2011 that I had bought Berkshire shares using Australian dollars. At the time I purchased the Berkshire shares, the Australian dollar was worth $US1.10 (this part was just good luck). So I picked up the A shares at an effective price of around $113,000. The Australian dollar then depreciated to around $US0.92 (again, good luck).

Therefore, in Australian dollars it worked out to a 23% annual compound return over the 2.5 years. An investment in $US would have yielded closer to 15% compound per annum, not as good as my return, but still a very nice return.

I will add that I’ve now sold the shares. I don’t think Berkshire looks anywhere near as cheap today and I have plenty of algorithmic trading opportunities (which is really my bread and butter these days).

Decades ago, one could buy Berkshire at almost any price and have obtained excellent returns. Those days are long gone. Today, those kinds of returns will only have a chance of being achieved if Berkshire is bought when the price-to-book value is at a very low level.

This is a very basic, long-term mean reversion strategy - buy when price-to-book is very low and hope it reverts to the mean. Well, it worked this time. And of course, my thanks go to the US Federal Reserve for allowing it all to happen.*

I’ve commented in other articles on the legions of Buffett acolytes out there, but perhaps the best observation on this is attributable to the hedge fund manager Michael Burry (who foresaw and profited immensely from the sub-prime crisis), quoted in Michael Lewis’s brilliant book The Big Short:

“At one point I recognized that Warren Buffett, though he had every advantage from learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules. I also immediately internalised the idea that no school could teach someone how to be a great investor, if it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

Most people have the opposite reaction, they see what Buffett has done, it looks relatively straight forward, so they attempt to emulate him, but they can’t. And this is why I wouldn’t be giving a cent to Buffett clones, but I may have more to say on this in a future article.

 *The policies of the US Federal Reserve are either brilliant or absolutely crazy, but I can’t work out which it is    right now.

Magellan: Flavour of the month, but will it last?

Magellan Financial Group has certainly been “flavour of the month” in recent times. The company’s shares trade on a high price-earnings ratio of around 26 and they have attracted plenty of media attention. They certainly have achieved good results, but as is so often the case, these results are over relatively short periods of time, and I would argue, due to a unique set of circumstances.
 

A look at the listed Magellan Flagship Fund or the unlisted Magellan Global Fund will immediately reveal the modus operandi of the company – buying large good quality (mostly American) companies at what they deem to be attractive prices (e.g. Google, Microsoft, Apple, Wells Fargo, Visa, McDonalds, Yum Brands and so on). Sound familiar?

Hamish Douglass and Chris Mackay, (the founders of Magellan), like so many Australian fund managers these days, are die hard Buffett acolytes. Buffett of course moved on from pure stock investing decades ago and the technological landscape has changed dramatically since his halcyon days.

The Magellan Flagship Fund annual report does make for some interesting reading, but not for the disclosure of investment holdings or the ubiquitous fees that investors must pay. The relationship between the fund and its prime broker (Merrill Lynch) is much more interesting.

The Flagship Fund’s balance sheet (30 June 2013) nets $120 million of borrowings from Merrill against cash held on behalf of the Fund with Merrill ($123 million). Instead of seeing borrowings stated as $120 million on the balance sheet and cash as $123 million higher than stated, you see no borrowings and cash stated as $3m more as a result of netting the $120 million in borrowings against the cash of $123 million. That’s misleading, but perfectly acceptable under our (sometimes bewildering) accounting standards.

However, when we start reading the notes to the statements we discover that Merrill has security over up to $200 million of the Flagship Fund’s holdings. Further, we are told that Merrill doesn’t segregate its own cash from the cash belonging to the Magellan Flagship Fund and that Merrill can use the Flagship Fund’s cash in the course of its own business!

So now we have counter-party risk on a fairly large scale. If Merrill were to become insolvent, the Fund becomes an unsecured creditor and could potentially lose up to $200 million of its investments!

Now these arrangements may be normal with the flashier modern listed investment companies, but any investor casually perusing the Flagship Fund’s balance sheet alone is probably not aware of the debt the Fund carries or the fact that there is significant counter-party risk.

An investment in the Flagship Fund is not the same as an investment in Argo, Milton Corp. or AFIC – these companies have much lower levels of risk (and are generally the preserve of older investors who live in the wealthier suburbs of Sydney, Melbourne and Adelaide).

Institutional investors have poured money into the Magellan Group – billions. But I do wonder why. Are they incapable of making direct investments themselves into the type of companies that Magellan invests in? Nothing Magellan is doing is rocket science, it’s hardly another Renaissance Technologies.

 

Yes, Magellan has achieved good results, but the set of circumstances that allowed them to achieve those results is not readily repeatable. The major factors that assisted Magellan’s results are:

1.    Quantitative easing in the US;

2.    The purchase of companies at knock down prices during the GFC;

3.    The purchase of US and other foreign securities when the $A was very high and the subsequent benefit of the recent depreciation of the $A against the $US and other currencies.

The influence of quantitative easing in Magellan’s results is absolutely obvious to me, there is simply no way their results would have been achieved without it. The Federal Reserve has engineered an American bull market through quantitative easing, but the party must end at some point.

Now I ask you, how many times in a lifetime do you think this scenario will repeat?

The enthusiasm for Magellan also makes me think of Platinum Asset Management circa 2007. The stratospheric prices that Platinum shares got to on its first day as a listed company in May 2007 were silly (and they have never reached anywhere near that level since – more than 6 years later). And no one seriously thinks that Kerr Neilson is an Australian (or dare I say, South African) version of Warren Buffett as some did back in 2007 and earlier.

Now Douglass and Mackay are not versions of Buffett either. They obviously have some skills, but are not in the Buffett league. They may get some more nice “free kicks” from the devaluation of the $A against the $US. Further, Australian domestic funds management businesses should prosper in an environment of extremely low interest rates and an Australian market that doesn’t seem over-valued to me (within the context of current interest rates). But please let’s not think of the folks at Magellan as some sort of new messiahs and value the shares at ridiculous prices. And please be very conscious of what quantitative easing has done for Magellan and what it will mean when it ends.

(The picture accompanying this article is of the famous Portuguese explorer Ferdinand Magellan).