Episode #13: Want Buffett’s Returns? Here’s How to Get Them
Guest: Episode #13 has no guest, but is co-hosted by Meb’s co-worker, Jeff Remsburg.
Date: 8/8/16 | Run-Time: 48:20
Topics: Stock picking is hard—really hard. Fortunately, there’s a simple strategy you could begin following today to improve your success. It’s simple to implement, takes just minutes of your time, yet has the potential to vastly improve your investing results. Sadly, if you’re like the average investor, you don’t even know it exists. So what is it? Well, consider the world’s star hedge fund managers – the Buffetts, Klarmans, and Teppers – the guys with average yearly returns in the upper teens and twenties. What if you knew what they were investing in right this second? Logic would suggest if you invested alongside them, you too could post their extraordinary returns. Well, it turns out, the option is available to you thanks to the SEC and Form 13F. This is a form professional fund managers with more than $100m in U.S.-listed assets must fill out. Best of all, it’s available to the public, providing you and me a way to “peek over the shoulder” of some of the world’s most successful investors. Of course, there are some issues with this strategy. For instance, there’s a 45-delay in reporting, there can be inexact holdings, and the biggest one – the fluctuating success of your chosen manager. Bill Ackman’s recent debacle with Valeant certainly comes to mind. No, it’s not easy; a 13F investing strategy takes dedication. Many of the star managers who post amazing long-term returns can actually underperform for years at a time. Would you stay invested alongside them long enough to ride out those barren stretches? Or would fear and second-guessing shake you out? Turns out there are a few ways you can improve your chance of success. Find out what they are in Episode 13.
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Links from the Episode:
- Investing with Third Point
- 9% Alpha with Munger & Van Gogh
- What Is a Better Strategy – Invest In Berkshire, Or Buffett’s Stock Picks?
- How to Beat 98% Of All Mutual Funds
- “The Capitalism Distribution” – Longboard Asset Management
- 2014 Berkshire Hathaway annual report
- TIAA-CREF study
- The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor – Hagstrom
- “Buffett’s Alpha” – AQR Capital
- “Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway” – Gerald Martin and John Puthenpurackal
- Foundations and Endowment Investing – Mark Yusko of Morgan Creek Capital
- “Rules of Prudence for Individual Investors” – Mark Kritzman
- “How Active is Your Fund Manager? A New Measure That Predicts Performance” – Martijn Cremers and Antti Petajisto
- EDGAR database
- EDGAR Online
Below are some great websites for tracking hedge funds as well as finding new investment ideas:
- Barron’s Roundtable
- Bloomberg Hedge Fund Brief
- CXO Advisory
- Filings Analysis
- Hedge Fund Alert
- Hedge Fund Letters
- Hedge Fund Wisdom
- Insider Monkey
- Insider Score
- Institutional Investor
- Market Folly
- Novus Partners
- SuperInvestor Insight
- Turnkey Analyst
- Value Investing Club
- Whale Wisdom
Below is a list of conferences that are a good source of new ideas, roughly in approximate order of the calendar year:
- Wine Retreat
- Ira Sohn
- Value Investing Congress
- Value Conferences
- The Big Picture
- Boston Investment Conference
- Grant’s Conference
- Invest for Kids
- Santangels Forum
- Barron’s Roundtable
- UVa Investment Conference
- Great Investors’ Best Ideas
- Bloomberg Global Summit
- Harbor Investment Conference
Books Profiling Top Hedge Fund Managers
Below is a list of books that profile top hedge fund managers.
You can also find this list on Amazon here: Hedge Fund Manager Profiles.
- Hedge Huntersby Katherine Burton
- Yusko, Armitage, Effron, Ainslie, Pickens, Anderson, Robertson, Loeb
- 20/20 Visionby Harry Liem
- Dalio, Inker, Beckers, Mobius, Harding
- The New Investment Superstarsby Lois Peltz
- Ainslie, Cooperman, Griffin, Henry, Tepper, Sussman
- Market Wizards by Jack Schwager
- Kovner, Dennis, Tudor Jones, Seykota, Steinhardt, Rogers
- The New Market Wizardsby Jack Schwager
- Lipschutz, Eckhardt, Trout, Druckenmiller, Sperandeo, Basso, Hull
- Inside the House of Moneyand The Invisible Hands by Steven Drobny
- Fooling Some of the People All of the Time by David Einhorn
- Money Masters of Our Time by John Train
- Buffett, Cabot, Fisher, Graham, Kroll, Price, Templeton, Tisch, Wilson
- The New Money Masters by John Train
- Soros, Lynch, Neff, Rogers, Caret
- Investment Gurus by Peter Tanous
- Price, Gabelli, Sharpe, Fama, Sinquefield, D.E. Shaw
- More Money than God by Sebastian Mallaby
- All About Hedge Fundsby Robert Jaeger
- Absolute Returnsby Alexander Ineichen
- Handbook of Alternative Investmentsby Mark Anson
- Profiting from Hedge Funds by John Vincent
Suggested Reading from Top Hedge Fund Managers
Below are a few more reading suggestions from various hedge fund managers:
- Dan Loeb’s Reading List
- Bill Ackman’s Reading List
- Seth Klarman’s Reading List
- David Einhorn’s Reading List
- Warren Buffett’s Reading List
Transcript of Episode 13:
Welcome Message: Welcome to The Meb Faber Show where the focus is on helping you grow and preserve your wealth. Joins us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor Message: This podcast is sponsored by the Soothe app. We all know how stressful investing in volatile markets can be. That’s why I use Soothe. Soothe delivers five-star certified massage therapists to your home, office, or hotel in as little as an hour. They bring everything that you need for a relaxing spa experience, without the hassle of traveling to a spa. Podcast listeners can enjoy 30 bucks to their first Soothe massage with the promo code MEB. Just download the Soothe app and insert the code before booking. Happy relaxation.
Meb: Welcome everybody to this summer time podcast series. We’re doing another research episode. We have a huge slew of really, really cool guests coming up in August and early September, so I wanted to squeeze in a few more of these. Jeff, co-host, welcome.
Meb: So today, we’re in the midst of political season, otherwise known as my least favorite time of the year. Before I start getting any feedback emails, look, I’m a registered Independent. Politics usually aren’t that interesting to me unless it has some sort of investment implications. I actually did a post today on the blog out of a little curiosity that I’m sure I’m gonna get some hate mail about. But we once wrote a paper on politics and investing called “Politics and Profit: Combining the Presidential Cycle and the January Effect,” which is by far our least read paper. So if you wanna read it, I’m not gonna talk about it today, it talks about cycles in investing, combining the four-year cycle, which is also known as the presidential election cycle, as well as kind of the January effect. Fun paper, not the point of today.
We’re also gonna record a podcast with Sam Stovall later today, and we’ll talk a little bit about that. Awesome, really excited about it.
But anyway, I did a little post on the blog today about Hillary Clinton. And many don’t know this, many of the younger crowd, but she’s actually one of the most successful traders in history. Jeff, did you know this?
Jeff: I had no idea.
Meb: I bet if I asked you to guess what market she traded, if I gave you 50 guesses, I bet you couldn’t guess. She was trading cattle futures. And so in 1978, Hillary turned $1,000 in 10 months into $100,000 trading cattle futures.
Meb: Exactly. And this was for the first time, by the way. She never traded them before. She also forgot to pay taxes on those gains, and that only became evident when Bill ran for president. So they had to pay back taxes. But if you can’t do the math, don’t worry, that is a solid one-year return of 9,900%.
So I wanted to do a fun math experiment and said… All right, so if you know markets in general, you know that it’s highly, highly, highly, highly, highly unlikely to make that sort of gain. She makes about what? Two hundred fifty grand a speech?
Meb: So I said, well, what if she just instead kept trading instead of becoming a speech-giver or a politician? So she would have turned that $1,000 into $700 million in only three years and trillions in less than 10 years. By 2009, she would be a vigintillionaire. I had to look that up. I think it’s vigintillionaire. And that was in 2009. In 2016, it was off the chart literally, the number of zeros. But let’s say she lost her touch a bit, and instead of compounding at 9,900%, she only compounded at 50% a year. She would still be the richest person on the planet at $300 billion.
Jeff: Well, it goes back to your podcast with Wes Gray, talking about these huge compounding numbers over many years gives you the entire market.
Meb: The impossibility of big returns, right. So remember, Bill Gates is only about what? $80, $90, $100 billion, and she would be at $300 billion. She’d obviously have to pay taxes on that in some way. So she should forget speaking fees and presidency, just go back to trading.
And so a lot of people say, “Wait a minute, is she just an amazing trader or whatever?” First of all, what happened likely is highly certain that it was illegal and immoral. But what happened back in the day, the only way you could achieve those returns is you have a brokerage, and the person placing trades for you, this is back before electronic records, would place the trade. If it’s successful trade, they place it into Hillary’s account. They take two sides of it. They trade the short side, or whatever, the opposite side into someone else’s account. And so you do this over and over again. And all of a sudden, it’s very simple to trade…translate $1,000 into $100,000. But it’s also of course illegal. So it’s a very shady way of donating, say, 100 grand to someone.
And Jim Cramer actually admitted to doing this in his first book “Confessions of a Street Addict.” I think enough time has passed that you’re not susceptible to wrongdoing at this point. But he talks about doing this, where he had clients that would wanna redeem out of his hedge fund, and he would put losing trades into their account instead of into his account. Anyway…
Jeff: That’s an interesting fund idea I should look into.
Meb: Yeah. You’d go to jail, but interesting.
Anyway, so if you guys remember, we did on one of my magical useful endings the other day, we were talking about Fiverr. And so it’s politics season, so I thought it would be fun aside to… If you’ve ever seen the show “Tosh.0” the comedian on Comedy Central, in the beginning he has an intro that’s “recorded by Obama.” And so the guy that did it, the disclosure, it’s like “Don’t do dumb stuff. You’ll kill yourself if you watch this show,” like the old Jackass shows, but had someone dub all of Obama’s speeches to basically “read the disclaimer.” And it’s really well done. So I actually emailed that guy and said, “Hey, look, we have this little podcast. It’s politics season. Curious if you could do this for both Hillary and Trump.” And he said, “Sure, but it’s gonna be like two grand.” So I said, “Well, I’m a cheap bastard. I don’t wanna pay that much.” So we went on to Fiverr and said, “Can we find someone to do this for like $5?” And I think it wasn’t $5. It was like $30.
Jeff: One guy was around 35 bucks, the other couple, around 80.
Meb: Oh jeez. I wouldn’t have done it if I know that big, Jeff. All right, so we’re gonna play both of those. Full caveat, these are horrifically bad. They might be horrifically bad. They’re so bad, they’re funny. And so we’re gonna play them, let you listen to them, see what you can do on Fiverr. Hillary first?
Jeff: Yeah, we can go with Hillary.
Meb: This sounds terrible. We’ll re-dub it. She had trouble saying Meb Faber strangely. She’s never said Meb Faber on camera. Go ahead.
Hillary: Welcome to The…Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Meb: All right, pretty horrific.
Jeff: Pretty awesome.
Meb: All right. Now, Trump’s is actually a little better. Let’s listen to…
Meb: Let’s go. All right, go ahead. He’s got a better ending.
Donald: Welcome to The Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Meb: I mean the Trump actually sounds better because I think in most of his speeches he’s shouting anyway, so the mash-up doesn’t sound as bad. All right.
Jeff: Sounds like Jerry Lewis.
Meb: Enough politics for the rest of the year. We’re not gonna bring it up anymore. Jeff, what do you wanna talk about today?
Jeff: Today, I’d like to talk about your 13F book. I’ve always been fascinated in that. And actually, this morning, news came out about Bill Ackman at Pershing Square putting up his last 6% in Canadian Pacific. And, you know, a lot of the speculation is he’s doing this to offset some of the valiant losses. So, you know, given your book about how you can track some of these superstar hedge fund managers and hopefully use it to your advantage in investing, I’d be curious what your thoughts are on the whole thing and…
Meb: So the book is “Invest With the House: Hacking the Top Hedge Funds.” This is actually the highest rated book I’ve written. For a self-published book, I think it’s by far the nicest-looking. We had a professional cover designer. And the girl that actually designed the cover art is from Transylvania. Did you know that? Yeah, so I contacted her on the internet. I said, “Hey, could you design a cover? You do wonderful caricatures in [inaudible 00:09:28] the internet.
Anyway, the origins of this book are all the way back to the year 1999. And I was a senior biomed student at Virginia. One of my big interests is always investing. So I had a stack of biotech Ks and Qs by my bed I would read in spare time. And like everyone else, including the professors in 1999, was trading stocks during class or in my spare time. There was some friends in the business school, it’s called the Commerce [SP] School of Virginia, and they said, “Hey, Meb, you should take this class in the spring. You’d really like called Security Analysis.” I said, “That sounds cool.” They said, “Well, you have to apply to the class.”
So I look it up, and the class is already full. Unfortunately, I couldn’t go. But I said, you know what? This is like the very early days of electronic classes. You could go online and see if a class is full or whatnot. And I saw that someone had dropped it. So I show up at the class, ended up getting into the class. I’m the only non-business school student in there. And the purpose of the class, and is taught by the former right hand man of Julian Robertson of Tiger, one of the most famous hedge funds of all time, and is John Griffin of Blue Ridge, and the purpose of the class is maybe a dozen, two dozen students, was stock picking and how you go about true value-added stock picking and both from the long side or the short side. It’s really a fun class, because your only assignment by the end of the year was that you had to present a stock idea to a panel of hedge fund managers. And that’s pretty fun for an 18…or sorry, 21-year-old kid.
And so, of course, mine was a biotech stock. And this being the year 1999-2000, I remember it so clearly, it was Human Genome Sciences. Do you remember this? HGSI.
Meb: Classic bubble stock. And I think by the time I picked the stock in January to the time I gave the presentation in May, it had done something like gone up 150% then back down like 60%, just preposterous moves. So subsequently, it went down 70% and then went up [inaudible 00:11:28]…I don’t even know if it still trades. We’ll have to look it up. But it’s really cool, because we would have all these guest speakers like…you know, we’d have everything from journalists like Herb Greenberg to hedge fund managers like Lee Ainslie and other tiger cubs is what they call them, people that spun out of Tiger, so guys from Viking and Lone Pine, etc.
Anyway, so when these hedge fund managers would come to the class, a lot of people don’t know this, but anyone who has over 100 million under management has to disclose their holdings publicly. And it’s called the form 13F. SEC publishes it online in a database called EDGAR. And it’s 45 days delayed. For the end of the year, it will come out in mid-February. And so what we would do is so to prepare for each of these guys giving a presentation, we’d print out their holdings, because we didn’t wanna sound stupid if we start talking and they’re like “Well, let’s talk about IBM” or whatever it may be, Yahoo. You know, we didn’t wanna be like “Hey, this is the best short idea ever” and look and see that they hold it, because these guys know way more about stocks and research than we do, hugely capitalized, have dozens of analysts.
Anyway, we’d print them out ahead of time. And after a few of these classes, I sat there, and I said…and I was, you know, again, the engineer, and I said these guys know way more about this than I ever will. They use accounting metrics I’ve never heard of. They talk about reading these footnotes in a 10K from five years ago and these disclosures. Why wouldn’t I just outsource my stock picks to them, you know, meaning why wouldn’t I look at these 13F filings every quarter and just buy what they buy?
And so this was an idea that sort of germinated in the back of my mind for many years thereafter. And so it wasn’t until probably 2007 when Eric and I started Cambria that I really started to think about this. And I said, all right, the same time I started writing the blog, I grabbed an intern, poor guy, then I said, “Hey, look, let’s see if we can start to back-test this. So we went out and we tried to cobble together, and this took like six months. So we had to download not only every 13F filing going back to 2000, but also find historical stock database that was survivor bias tree[SP]. So stocks that either had been merged or acquired or whatnot still existed in the database and include all total returns, corporate actions, everything. So we actually use a database called Norgate, which I think is from Australia and shockingly cheap, by the way.
Anyway, we did this, and we started to find some really interesting results. We used Buffett as the first test case. And then after we did this, we started writing on the blog about this. And we started tracking it in real time. And so I emailed about a dozen of my buddies in the hedge fund space, fund of funds space, and said, “Hey, guys, name a dozen hedge funds that if you could put money into, you know, you would give them money.” And so we started to cobble together a list of investors. And so we started testing more and more of this. I started writing more and more of this. I had a guy reach out to me, Maz Jadallah, and said, “Hey, Meb, I’m thinking about building a business based on this. Would you like to help consult, co-found it, whatever?” And that ended up becoming AlphaClone, which is a wonderful database that is now private, no longer publicly available, which is a shame.
But let’s take a step back. So we’ll start to talk about 13Fs in general and the theory of this and what it is and how it works. So that’s the origin story, as they would say in comic book land.
Let’s take a step back and say, all right, these guys…and as we say this in the beginning in the book, we say, for this theory of can you copy, piggy-back these guys, is it even possible…two questions you need to ask or two statements. One, are there active managers that can beat the market? So meaning is the market actually efficient? And if you believe the market is efficient, you need to stop listening now because the rest of this podcast will be boring to you. And two, can you identify those superior managers?
And so the book takes you through this process of saying, look, we believe it’s not totally efficient, and, yes, I think you can identify these guys ahead of time. Even Charlie Munger has a great quote that we open the book with, where he says, “I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting there and trying to dream it up all yourself. Nobody is that smart.”
Here’s the challenge, though. So as a stock picker, the game is rigged against you and in two ways. The first way is that the odds are stacked against you. We’re gonna talk about this next week with a good buddy of ours from Longboard Asset Management. But they have a study called “The Capitalism Distribution” where they found that…they looked at top 3,000 stocks back to 1983. Sixty-four percent of stocks underperform the broad market index, so straight up. You got two-thirds chance of underperforming the index if you pick a stock out of a hat. Thirty-nine percent of the stocks aren’t profitable, almost half. So if you literally throw a dart against the wall, you almost have a 50-50 chance of picking somebody who’s gonna lose money. Nineteen percent of the stocks lost at least 75% of their value. Twenty-five percent were responsible for all the market gains.
And that’s the way that it should be. It should make sense. You have these small big winners that make up for the overall performance in the market. That’s the point of why the classic Burton Malkiel, “throwing a dart against the dart board,” chances are you may end up with a losing stock. That’s why you need a lot in your portfolio if you’re gonna index to guarantee you on the winners.
All right, so the odds are against you. However, can you find active managers? And I think, you know, much like looking at basketball, you know, is it that hard to identify Michael Jordan? I don’t think so, right? And there’s a lot of common sense that goes with this, and we’ll talk about it a little bit. But how many people would look at Warren Buffett as a classic example and say, at what point did you know he was talented? Certainly by 1970. 1980, obviously, 1990, 2000. I mean there’s many decades of outstanding outperformance. We’re gonna take you through Berkshire and Buffett as a case study and then kind of illustrate a few more and talk about it.
Jeff may be falling asleep here, but we’ll just keep going.
Jeff: I’m saving my questions.
Meb: So Buffett, one of the richest people in the world, here’s a perfect example. What if you could just copy him? So let’s say you went back 2000. You said, “I’m gonna start following him in 2000.” And that’s when the electronic records became available. They’re actually available in paper form in the SEC reading room in D.C. So if you’re enterprising analyst, you could go to D.C. and download all these for all the managers all the way back to the 70s. But we’ll start in 2000 because that’s when electronic became available. Let’s say you were to buy his top 10 holdings equal-weighted. And the reason we do that is, one, is because it’s simple. Two, it kind of compares the managers apples to apples. Three, almost all these managers have a majority of their portfolio on the top 10 holdings, and many of them in the top 5. You can also weight them like the manager weights them. So if somebody has 30% in the top holding, you would weight them like that. The results are fairly similar. In general, equal-weighting the 10 actually does better. And it’s true for Buffett as well.
Let’s say you go back to January 2000, and you start tracking Buffett’s portfolio. So we’re only gonna update this portfolio when the data becomes available. So 45 days after the quarter in, we tack on another 5 days just to make it even more conservative. And we say we buy the portfolio then.
Jeff: Wait, real quick. Are you gonna talk about that 45-day lag at some point? The obvious question is are you potentially getting outdated information that’s gonna affect your returns versus the manager’s returns?
Meb: We’ll get to that in a minute. We’ll talk about the mechanics first, and we’ll get to that in like two minutes.
All right, so we start updating the portfolio four times a year. We buy the 10 holdings equal weight, make any rebalancing every quarter, and that’s it. It takes five minutes a year. Not to backtest, it takes many hours to do this…build this in Excel.
Let’s say you updated the most recent portfolio of Buffett’s. You know, it’s a laundry list of current names that he and Munger own as well as the new lieutenants. You recognize Kraft Heinz, Wells Fargo, Coca Cola, IBM, American Express, yada, yada. Buffett doesn’t have actually a lot of turnover. So what does it look like? Had you copied Buffett back to 2000, you would have outperformed the market by five percentage points per year. That’s an astonishing amount. That beats, let’s call it, 98% of all mutual funds. And you don’t have to do anything. And we actually show in a couple of blog posts, say, what’s better, investing in Berkshire, investing in Buffett stock picks? And Buffett stock picks actually beat out Berkshire by a little bit. They’re both good investments. You could do fine with either. But Berkshire gives you the operation company. It gives you the private company, etc., etc. They’re both fine. But they both crush U.S. stocks.
And there’s actually an AQR paper that came out that took this back to the ’70s. And back to the ’70s, Buffett outperforms by like 12 percentage points per year. So it’s even more ridiculous number. But as he’s gotten bigger, the size is obviously a lot harder to outperform, but there’s always the question of like why wouldn’t you just give all your money to Buffett? And I think that’s a totally valid answer. I think that is a reasonable thing to do.
In that paper, they said they also came up with an algorithm that just cloned Buffett’s methodology, and it actually performed great as well. We’ll maybe come back to that later.
Jeff: My issue with that, and I’m sure we’ll get into it though, is we talked about how he beats the returns of the market per year. And you’ve talked about it on other podcasts. Long-term averages have a way of hiding short-term variability and volatility. I know one of my challenges in this would be, and probably that of most investors, is you would begin to follow one of these guys expecting those sort of long-term average returns. And then you forget that in a given year, you can have outliers. You can have significant underperformance. And you don’t have the endurance or faithfulness to write it out and sort of capture those long-term averages. To me, it seems like you would have to master the psychology of this before you even really invest with them.
Meb: Well, it’s like any investment approach, particularly active ones, Buffett’s, for example. So his clone, what you would call it, where you replicate this strategy… I mean Buffett is a value investor. We all know that. So this strategy would have outperformed 5% a year back 2000, so 2000 to 2016. It would have outperformed from 2000 to 2000 and…what is that, 6? It would have outperformed five out of seven years, dominated. We talked about this a little bit with Greenlight in a prior podcast.
Since then, this clone has underperformed seven of nine years.
Jeff: Yeah, exactly.
Meb: Including the last four in a row. It’s actually six out of the last seven. And so any investor following a value style or a Buffett style, Wes calls it the value pain train recently, would have…and had you masked it and not called him Buffett or just called him manager XYZ on Morningstar, he would have been fired in 2010. If not 2010, certainly 2011, 2012 or 2013. I mean no one outperforms seven out of nine years. And so the thing about it, if you’re an individual investor, and going back to the State Street stat we talked about in the last podcast or two ago, where we said, they queried a bunch of institutions, and they said, “What percent of you would fire a manager after underperforming one or two years in a row?” And it was 99%. And so Buffett, six out of the last seven, so forget about it, they’d fire Buffett.
Buffett’s huge value add was that one, he knew value worked a long time ago, but we’ve known this since Ben Graham a hundred years ago. But he knew that the biggest value add was sticking with it. A lot of people simply can’t do that. So in the last few years, they would have sold all their value stocks, bought who knows what else, high yielding REITs and high dividend stocks probably. But…
Jeff: What do you think the minimum hold period is?
Meb: So once you identify these managers…again, we talk about your cell criteria, picking an active manager is a little tough, because you’ve got to come up with all these reasons of why you would sell, and we’ll talk about this in a minute.
So talking about 13Fs in general, there are some pros and cons to the strategy. We like being totally transparent. A couple of the pros are, one, access. So a lot of these hedge funds you couldn’t allocate to. Even if you wanted to, they’re closed. Even if you’re on endowment and wanted to give them 10 or 20 million, they might be closed. So this is one way to access a lot of these managers.
Mark Yusko, who runs Morgan Creek, famously says, “We don’t wanna give money to the people that want our money. We wanna give it to people that don’t want it.” So this gives you a way to access some funds that no way an individual investor could access to.
Two, you get a lot of transparency. You know what you hold. If you allocate to a lot of these private hedge funds, you don’t know what they’re holding. You know, you may get a quarterly update, or you may have negotiated it. But in general, you get pure transparency. And in something like a Galleon, which turned out to be a total fraud, which, by the way, we used to clone and could never figure out why it had such horrific performance, and it turns out that there was insider trading around earnings announcements. So it actually would show you something like this. It’s a little bit of fraud avoidance, by where you could use it as a check to look at their portfolio and say, “Hey, your portfolio clone is horrific. You’re doing amazing. You must be doing something else. So maybe you’re day trading or using futures or options or something else. But we need to know, because it’s a red flag.”
You also get liquidity. A lot of these hedge funds have quarterly, yearly lockups. I mean I think Ackman has something like a two-year lockup you were just talking about. So you don’t have to worry about that. So if something bad happens elsewhere in your life, you can just go sell your stocks. You don’t have to worry about trying to get a gate up. A lot of these hedge funds put gates down in 2009.
The biggest one is lower fees. The standard hedge fund fee schedule is 2% management fee, 20% performance. And that doesn’t sound like a lot. But let’s say your hedge fund does 20% a year, gross. You lop off the 2% management fee, you’re down to 18%. You lop off the 20% performance fee, which is another 3.6, that gets you to 14.4. So you gave up 6.6 percentage point in returns just on fees alone. So you can allocate to these guys and pay nothing. And a lot of people say, “Meb, these hedge fund managers must hate you.” And I say, “Well, no, they actually should be sending me bottles of champagne, because by definition, this tracking strategy is always delayed.” So you’ll always be buying what they’re selling by definition. But a lot of these managers, their value add is not in the timing. If you look at Buffett, there’s plenty of times when he buys a stock, and it continues going down the next quarter or the next year. It may get an initial pop. But there’s many cases where you can buy stocks that he bought that are then lower than his purchase price.
You can also obviously manage these with tax management strategies, which you can’t do in hedge funds. Hedge funds are notoriously tax-inefficient.
Of course, there’s also some cons of using 13Fs. So first, you don’t get a hedge fund manager’s portfolio management expertise. So if the portfolio manager has a value add in how he position weights or the timing of the investments, you lose that. But I would argue that that’s probably not their huge value add. It’s probably in the stock picking, not really in market timing.
There’s some screwy things that managers can do. So they can move positions off their balance at the end of the quarter if they wanted to hide something. It’s not really supposed to do that. But they do it all the time. They can have a high turnover strategy. So you really don’t wanna allocate to funds that super high frequency traders. They could also have arbitrage. So it may say that their long GM on their portfolio, but they may actually be short elsewhere. And so shorts don’t show up. Derivatives don’t show up on the 13F. It’s longs only.
Jeff: Yeah, you really have a smaller universe here of managers who are primarily long-focused, right?
Meb: Great point, you’re cloning their long-only book. But I think over the years, you’re starting to see a lot more of this, is that I don’t think the vast majority of managers generate any alpha[SP] on the short book. You know, they say they do, and it’s a reason to justify the 2 and 20 fee. But I’ve seen so many managers where you break out the long and short performance, and the shorts are really there to buffer the volatility and reduce the net long position. But even a lot of these managers will admit that they don’t have a whole lot of value add. Now, Jim Chanos, guys like this, maybe they do. But in general, a lot of these guys, short is a way of justifying their book. But I don’t think they actually generate a lot of alpha on the short side. It’s tougher. There’s a lot of reasons it’s harder. But in general, if a lot of funds do arbitrage-type strategies, it’s harder to really trust out what they’re actually doing. And then of course, the 45-day delay, which we talk about.
So we looked at this and we said, “Does this matter? Because a portfolio manager could have bought a position Jan 1, and that’s not gonna show up in the 13F until February 15. So there’s a pretty long delay. And then he could have sold something right after the quarter. And that’s not gonna show up for whatever it is, another 90-plus, 45 days. So we said, “Does it matter?” So we went and tested about a dozen managers. We said we’re gonna give foresight as moving their positions back to the end of the quarter and then also all the way back to the beginning of the quarter. And what we found is some managers that help, some that hurt. On average, it reduced the portfolio returns by about one percentage point a year. So it’s a drag, but it’s not a big drag, because a lot of these guys, like Buffett, he’s beating by five percentage points. It’s not a big deal.
So you really wanna target stock pickers with long-term time horizons, that aren’t trading on the [inaudible 00:28:44]. They’re not doing anything weird with futures. They’re not doing anything weird with arbitrage strategies. So Buffett is really kind of the perfect example. And then we go through in the book, and I described, I think, about 20 in the main part of the text and then another dozen or so in the end. There’s a few other strategies that you can’t clone, so black box, so like RenTech, Renaissance Technology. I can’t believe how many times I’ve seen people talk about the 13Fs for Renaissance or Bridgewater. And they’re trying to tease out some details of what these guys are doing. You’re like, wow, this makes no sense to clone these guys. It makes no sense to clone guys who are big futures traders, global macro, [inaudible 00:29:21] short only, high turnover.
Jeff: Let me sort of switch gears here a little bit. Practically speaking, do you follow any of these guys? Do you implement this yourself?
Meb: I love following these guys. And we do not have a strategy yet that’s public for people. But I’ve been doing it either in my own accounts. I used to say on the blog for the longest period, I said Baupost is my entire IRA. Then eventually, as Cambria started launching public funds, I wanted to demonstrate that we have skin in the game, I believe in our strategies. So I have 100% net worth in our strategies. The question is will we launch one eventually? I think you will or something with some 13F theory behind it at least or public disclosure theory, because there’s some other ways you can work with this too.
But I think these managers, there’s so much to find in what they do. And the hedge has been deluded a little bit. You know, the game of hedge funds for the longest time was kind of gray insider information. So I’m gonna take out the CEO. I’m gonna get him drunk and listen to him expose guts, cry over his sake about how terrible the business is doing. But now, it’s just more of the little bits. So it’s a lot of publicly accessible value added, so using satellite data to track store sales at Target or hiring private investigators to spy on oil fields in Africa. I mean the stories that I hear from my hedge fund manager buddies are just unbelievable, the ends of the earth they go to.
And Ray Dalio, who manages the largest hedge fund of all time, and this is kind of the reason we have a poker table on the cover of the book, is he has a great quote. It’s a long one, but I’m gonna read it. He goes, “The bets are zero sum. In order for you to beat me in the game, it’s like poker, it’s a zero sum game. We have 1,500 people that work at Bridgewater. We spend hundreds of millions of dollars on research. We’ve been doing this for 37 years. And we don’t know that we’re going to win. We have to have diversified bets. So it’s very important for most people to know when not to make a bet, because if you’re going to come to the poker table, you’re gonna have to beat me, and you’re gonna have to beat those who take money. So the nature of investing is that a very small percentage of people take money essentially in that poker game away from the other people who don’t know when prices go up, whether that means it’s a good investment or if it means it’s a more expensive investment.”
Jeff: All right, so I see a huge challenge presenting itself with this strategy, because on one hand, you need to invest with these guys long enough to benefit from their long-term average. But on the flip side, you don’t want to expose yourself to significant drawdowns if they’ve had style drift, if the divorce is affecting them, if, if, if. So there’s some sort of subjective criteria in here on when this time is different, and when you have to bail. So if you actually launch this, what kind of criteria will you use to get out, versus, you know, shooting yourself in the foot and you realize, oh, well Buffett was down four years, but then if you’d stayed in, he would have crushed the next few years?
Meb: Unlike many quant strategies that are data-specific and based on history and factors and trends, this is more of a subjective business of allocating the hedge funds. So whether you’re Yale [SP] or anyone else, it benefits you hugely to have a little bit of domain expertise. And there’s a lot of great sites that write a lot. Novus is probably my favorite. It puts out a lot of research on these hedge funds. But so if you have a couple of hedge fund buddies that work in endowments or fund of funds, it certainly helps. And it helps to pay a lot of attention. And so, one, you could buy our book. There’s 20 profiles of managers that I would allocate to, everything from Appaloosa, David Tepper. I mean I think his clone beats the market by like 12 percentage points a year. My favorite of all time is Seth Klarman at Baupost, famous Republican that just came out for Hillary. He wrote a book called “Margin of Safety” that regularly…it’s out of print and goes for $1,000 on eBay. This is incredible. He’s an example of managers I like. So I’ve mentioned this before, but I really like the managers that are unique. A lot of managers end up in these hedge fund hotel names. So Valiant’s a perfect example. If you look at the managers and how many own these names…so we’ll talk about a few quirks of 13Fs now.
One of the things that people assume is a great way to invest is they assume that the manager’s number one position is their highest conviction idea, and that should be their best idea. And that’s not true. And I actually talked with Mark Yusko years ago about this before I was building this, and I [inaudible 00:33:39], and I said, “Hey, what’s your input?” And he goes, “Look, it may work. It may not work. I don’t know. But I will tell you I don’t think the top position is their best idea.” And I said, “Well, that’s counterintuitive to me. Why do you think that?” He says, “Well, one is that by the time it becomes their largest position, it’s likely because of appreciation, meaning the stock has gone up 50%, 200%, 300%, 500%.”
Jeff: It’s the same reason you don’t like market cap weighting.
Meb: Yeah, so it’s almost like an inadvertent market cap weighting in your own portfolio, is it too the 45-day delay will actually exacerbate that. That actually shows up in the data. And so we published it in the book, and we said the top position is actually the worst of the top 10 to clone. So if you’re gonna look at these guys, one, it’s totally okay with excluding the top one. Two, you wanna diversify across managers. So I think it’s perfectly rational to buy 5 or 10 managers. If you wanna keep the portfolio small, you could buy holdings 2 through 5 across 10 managers. And you end up with a nice size portfolio there.
Two, I think you wanna avoid the broad hedge fund name. So if you look at a lot of these hedge fund industry, so there’s 10,000 hedge funds. And you see these reports come out of Goldman or in The Journal about the most popular hedge fund stocks. You don’t want the beta of hedge funds. You don’t want the broad hedge fund industry returns because they’re crap. And you just end up with basically a shittier version of 60-40. You don’t want all these portfolios that just have the names that everyone owns. You want the unique name. So…
Jeff: Well, so if you have five managers and they all share the same one stock, you would stay away from that actually?
Meb: No. So I would stay away from the names the entire industry owns. So you can screen for the most popular stocks across all hedge funds. So we used to joke and we actually had a ticker reserve for a long time. It’s one of our favorite things to do here is reserve tickers. And so I can say this because we don’t have this anymore. But we had CRWD, I think is C-R-W-D, where we said we’re gonna buy…or sorry, we’re gonna short the top 20 hedge fund-owned stocks. And Goldman calls this the VIP basket. And it’s a terrible strategy. It does very poorly. And on top of that, a lot of the studies that put this out used survivor bias data. So all the hedge funds that failed, it doesn’t include the hedge fund-wide failure rate. So it’s a terrible way to invest. So we would exclude those.
If you pick 5 or 10 managers who were all buying some screwy stock you’ve never heard of, I would not exclude that at all. And so Baupost, look at his top 10 holdings, EMC, ViaSat, Antero Resources, Allergan, PayPal. And he owns a lot of weird biotechs as well. But he’s a good example for a couple of reasons. One, outperforms six percentage points a year. Two, he’s in a major drawdown right now. His portfolio must be down 40% or 50% from peak. He owns a lot of energy names. So probably a wonderful time to be allocating to one of the top managers in the world.
Two, his equity book is only a fraction of his total portfolio. So he owns real estate, private investments, a lot of distressed debt. So a lot of people will look at Baupost and say, “Oh, this only shows a few billon or whatever. Doesn’t he mange like 20 billon?” It’s a great example where someone’s portfolio, the equity portion is not the entire picture. But I think he had one of his only down years ever maybe last year. Anyway, he’s a good time to be looking at his stocks in general as well.
Jeff: To what extent would the limelight play into whether you would or would not wanna invest with any of these guys? And under that question is sort of a different one where you look at Ackman, it seems like the press loves to kind of put his failures in the limelight. That’s got to have effect on the psyche. It’s got to potentially influence what he’s doing. Like I can’t imagine that some degree of pride wouldn’t be involved with why he’s still in Valiant.
Meb: Ackman is much more fun to watch on TV when he’s winning. He’s one of these guys that he’s like…he does much better with the bravado then kind of being shamed. So when he’s come on TV after these stocks have lost a lot of money, it’s kind of like looking at like a puppy that’s been kicked, Certain people do much better with a lot of bravado. So we put Ackman in the back of the book because people like following him, are interested. It’s not someone that I would clone. You know, he blew up a fund before starting Pershing Square. You know, he does a lot of things that I would classify as not someone I would wanna allocate to. He tends to go in these all in crazy bets that often don’t work out. I mean he had a fund that I think used to just buy Target calls. Essentially, the entire thing went to zero, right?
So just kind of a lot of his behavior, you know, lends to characteristics that I probably wouldn’t want in a money manager. I mean I like the guys that are humble. I like the guys that are very…you know, they say, “Look, I could be wrong, I don’t know.” Suarez [SP] talks about this all the time. He says, you know, “Look, I’m wrong all the time. Anyway…
Jeff: Well, pulling away from Ackman, though, back to the idea of in the limelight, does that make a difference to you?
Meb: Well, let me look someone like Einhorn. You know, he’s someone we talked about in some previous podcasts who destroyed it for the better part of 2000. Super nice guy, humble, comes from an accounting background, which is a huge plus. I mean he probably does add value on the short side. But for whether it’s because he’s moved into global macro, whether it’s because he has outside activities like trying to buy the Mets or play poker, whatever it may be that’s not money management, whether it’s because he’s simply too big, whatever, his returns or value has just done poorly for the past eight years. His returns on the 13F are a story of two periods, first part of 2000s and then later. So much like Buffett, it could just be a scenario where value hasn’t worked. So he’s done very poorly.
And so you have to ask yourself these questions, and there are not easy answers I don’t think of has a manager got too big? Can he still replicate what he’s done? And I think that’s a tough question. And there’s other ways you could do things. So there’s groups of people.
So if you look at the Tiger cubs for example, and say, look, there’s all these funds that have spun out of Tiger and they come from a similar methodology. So they all learn from Julian Robertson. They have a similar style. So if you type these guys up, and Novus has a tool that can actually do this, and compare their holdings, most of them own the same stocks. You’ll say, “Hey, does he own XYZ?” Well, and like 14 of them will own it, right? So these guys have dinner together. They chat.
So I would actually group them as a collective intelligence, 1 fund style rather than 12 distinct funds. And so you can do things like buy the most popular stocks amongst that group or buy maybe a handful of them but consider only one allocation rather than a bunch of different ones. I mean the fun thing about this book is there’s a lot of characters in this industry. You read about Cannell who’ll be speaking at this Stansberry event in Vegas that I’ll also be speaking at in the fall. So if you go, let me know, come say hello. But he’s a character. He owns stocks that I almost always have never heard of. So he’s a fun one to clone. So we shared a few other examples. PAR [SP] is one of my all-time favorite hedge funds that most people don’t know about, who have just absolutely destroyed it. I got a buddy that works there, and he hates me talking about it. So I won’t spend any more time talking about it.
And some other ones we included like LSV, which is actually a quant shop. So you’ll see that their bets are much smaller, the largest position maybe like 3%. But a lot of these guys will end up having positions that are actually pretty huge. And there’s a lot of fun names on here to talk more about. But we’ll kind of wind it down because otherwise I’ll just keep blabbing. This is a really fun area. And by the way, since we started publishing on this, we actually wrote about this in The Ivy Portfolio 2008. And for a while, there’s so much misinformation on 13Fs. And it drives me crazy, because a lot of the journalists will talk about it and say, “It’s impossible. You can’t track 13Fs.” And I’ll write an article about it then stop being frustrated for a few months and see another terrible article. And so finally, this book had to come out mainly because I was tired of writing these articles. But we used to track the portfolio we published in Ivy every year. We did it for like six years, and I got tired of publishing it just, because every year, they beat the market by about five percentage points a year.
So there’s a lot of out of sample data that validates this approach. There’s a couple of funds that do it publicly. You know, I can’t comment on their methodologies because they’re not public, but I do know one, our friends at Global X, they do a little different than the way that I would do it. They focus a little bit more on the popular ideas. But in general, I think it’s a wonderful, wonderful way to… Hey, even if you’re not gonna outsource your hedge fund allocation… By the way, I’ve spoken to plenty of endowments. They’re like, “Meb, don’t tell anyone this,” but we run a portfolio based on this. We don’t wanna tell because otherwise these managers will stop taking our calls and research sessions and allocations, but we’ve been doing this for years.
Jeff: All right, so tell me this. I feel like part of my role here it to try to take this information from you, sort of the theory, and distill it down to the actionable and practical for your listeners. So how do you really implement this in an asset allocation model, because it seems like this is more strategic versus asset-based?
Meb: This is gonna be a long-only equity portion for U.S. So let’s say you have a global asset allocation that’s 20% each U.S. stocks, foreign stocks, bonds, real estate, commodities. Well, this would be part of that 20% U.S. So you could say, all right, I’m gonna replace my S&P 500 allocation with…I’m gonna go in and buy holdings 2 through 5 of the top 10 managers. So that will be, whatever that is, 40 stocks.
Jeff: Seems like you’re risking like concentration risk. They’re going from like indexing like hundreds of assets…
Meb: Well…but indexing we’ve shown…I think we talked about this with Wes. Once you get above 20 stocks, and assuming they’re not all in the same industry, you’ve achieved most of the benefits of indexing, and certainly once you get to 40. So, yes, will there be tracking error? Absolutely. But that’s the whole point. You wanna be concentrated. So there’ll be years when you under or outperform by 20 percentage points. That’s a good thing, though, because over time you’re looking for that alpha. But so you have to be [inaudible 00:43:11] enough. You don’t wanna own 5 stocks. You don’t wanna own 300 because you’re gonna start to dilute it. But so somewhere in that, let’s call it, for an individual, 20 to 50 is totally reasonable. You can go on a lot of these commission-free platforms now, Robinhood, Motif, and you can execute a lot of the folio, execute a basket of these trades for very low costs. You update it once a quarter when the data is available. There’s lots of sites that update it for free, Whale Wisdom, GuruFocus, Insider Monkey. You can even go to the SEC website. So they all publish the data for all these funds.
Jeff: So theoretically, you could replicate this for your European or global allocation as well too?
Meb: So most of the foreign exchanges don’t publish this data. They do in Europe for some cases. Actually, they do in Europe for even some of the shorts. And I forgot to mention earlier, a lot of these managers, like Buffett tries to do this all the time, he’ll try to say, “Hey, SEC, you can petition to not include a position on your 13F.” It may be for trying to take over a company or build a position in a really small company. SEC often says…I mean, they petition all the time, but SEC often says, “No, forget it. Don’t be silly.”
And there’s a lot of people that…you know, the reason this exists is for transparency. A lot of people wanna see that these funds, you know, are doing what they’re supposed to be doing and the shady hedge funds. But in reality, I mean, if you were to say, “Meb, do you think this is really something that benefits the capital markets?” No. I think it benefits me. You know, I love seeing what these guys own, but do I think they should have to disclose them? No. Do I wish they had to disclose the shorts and derivatives too? Yeah, I would love to see that. Then you totally replicate it. What you do, you replicate part of your equity portion. B, you could also turn it into a more hedge fund-like strategy. So you could use futures or options or inverse, ETFs or shorting the spiders to hedge out part of your equity exposure. Instead of running 100% long, you could run it 60% net long or totally market neutral. So that’s a cooler way of getting low-vol exposure to hedge funds. Or you could even do a trend volume approach where you’re shorting or exiting the positions when the market’s below its long term trend, which, as we know, hasn’t happened in a gazillion years but eventually will happen at some point.
So it’s a really fun strategy to be able to replicate. I have cautioned against people to pick and choose the names. You know, a lot of times people…and Greenlight talked about this, with formula investing, a lot of people will try to pick and choose and will invariably end up excluding the stocks and not doing the best, because they may have…but is a wonderful…we used to call this idea farm before we started the idea farm, way to generate new investing ideas. And by the way, all these hedge funds look at the other hedge funds. They say they don’t, but I know a lot of these guys, they always are aware, hey, did you see what Buffett was buying? Did you see what Seth Klarman’s buying? Did you see what Einhorn just bought? So there’s a lot of incest in the industry as well.
Well, good, wind this down, Jeff, as we mentioned before, is tapped out on his useful, beautiful ideas. I’m gonna give one that’s actually gonna become a sponsor. But I reached out to them because I love this app so much, I actually became a shareholder and bought some in one of the crowdfunding websites. But Soothe, S-O-O-T-H-E, is one of the two massage-on-demand apps, the other one being Zeel, where you can basically order up a massage, Uber, essentially. So their pre-vetted, awesome masseuses come to your house. You can get whatever, Swedish, deep tissue, pre-natal, you can get it for an hour, 90 minutes. They bring a whole massage bed. So you don’t really have to do anything. It’s pretty awesome service. I have an invite code. We’ll give you 30 bucks off your first massage, and that is MEB, M-E-B. Oddly enough, it was just random. They gave me the invite code. It was MEB.
Jeff: I’m gonna use mine this weekend probably.
Meb: Anyway, check it out, it’s a lot of fun. We’ll wrap this up.
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