13F Strategy vs. Allocating to Hedge Funds: Benefits and Drawbacks

To summarize some of the differences in managing a portfolio based on 13F filings versus allocating an investment to a hedge fund manager, the following list is helpful.

Access- Many of the best hedge funds are not open to new investment capital, and if they are many have high minimum requirements (in excess of $10 million in many cases). As Mark Yusko, owner of Morgan Creek Capital, said in Foundations and Endowment Investing, "We don't want to give money to people that want our money. We want to give it to people that don't want it."

Fraud & Transparency- The investor controls and is aware of the exact holdings at all times, thus eliminating fraud risk. See Madoff.

Liquidity- The investor can trade out of the positions at any time, versus monthly, quarterly, or longer lockup periods at hedge funds.

Fees- Most funds charge high fees, the standard is 2% management and 20% performance fees. Fund of funds layer on an additional 1% and 10%. These fees would require a portfolio to generate 17% gross returns to deliver a 10% return to an investor. The fees associated with managing a 13F portfolio are simply the investor's routine brokerage expenses.

Risk targeting- The investor can control the hedging and leverage to suit his risk tolerances. Blow-up risk from leverage or derivatives is eliminated.

Tax management- Hedge funds are typically run without regard to tax implications, while the investor can manage the positions in accordance with his tax status.

Potential drawbacks of the 13F strategy versus allocating to a hedge fund manager:

Expertise in portfolio management- The investor does not have access to the timing and portfolio trading capabilities of the manager (could also be a benefit).

Exact holdings- Crafty hedge fund managers have some tricks to avoid revealing their holdings on 13Fs; shorting against the box and moving positions off their books at the end of the quarter are two of them. The lack of short sales and futures reporting means that the results will differ from the hedge fund results.

Forty-five-day delay in reporting- The delay in reporting will affect the portfolio in various amounts for different funds due to turnover. At worst, an investor could own a position the hedge fund manager sold out of 45 days ago.

High turnover strategies- Managers who employ pairs trading or strategies that trade futures are poor candidates for 13F replication.

Arbitrage strategies- 13F filings may show that a manager is long a stock, when in reality he is using it in an arbitrage strategy. The short hedge will not show up on the 13F.

In our next blog we take a look at Warren Buffett as a case study to demonstrate how this process works (the short answer, great!). A simple clone of his top 10 holdings beats the market by over 9% a year since 2000 and is outperforming this year by over 15%.