In my last article, we discovered that the very highest-conviction picks of fund managers have a tendency to radically outperform the rest of their holdings. Much of the mainstream press criticises active fund managers for their inability to outperform the market, but perhaps all that expensive investment training hasn't entirely gone to waste. They really can pick winners... just not that many of them.
We described an approach to separate the wheat from the chaff in fund holdings by ranking each according to their risk-adjusted deviation from a benchmark weighting. While it's intuitive to investigate fund manager ideas at the individual fund level, we've also found ways to tap into this knowledge at the firm level.
Tapping into the best ideas at the firm level
A 2009 research paper "Best Ideas of Mutual Fund Managers" by Lukasz Pomorski of the University of Toronto investigated whether the common trades of fund managers working at the same firm could continue to beat other trades and the market as a whole. Pomorski classified these purchases made by multiple funds at the same firm as 'best ideas'. "These trades, likely generated by centralised research, outperform benchmarks and other trades by as much as 47 basis points per month."
In other words, identifying and purchasing the stocks bought across multiple funds at the same firm brings outperformance of almost 6% per year. Pomorski found these stocks continue to outperform over the next quarter after identification, the effect getting stronger when three or more funds trade, and strongest when at least four funds trade the stock.
Sail in the wake of herding institutions
It isn't only Pomorski who has discovered that institutional trading in herds has a continued positive impact on share prices. Nofsinger and Sias in 1999 found no tendency of the strong returns to herd trades to revert in the year after identification. Increased liquidity in stocks attracts growing institutional interest, which continues to push up share prices in a virtuous loop. Elephants may not gallop, but whales move rather slowly as they feed - if you can piggyback a ride on their best ideas, it does appear you can make yourself handsomely better off.
Is it ethically wrong to clone the best ideas of fund managers?
Fund managers in the USA have built a chorus of disapproval about the increasing numbers of websites and ETFs designed to profit from their best ideas. Indeed, many believe it unethical to piggyback expensive institutional research processes without sharing the cost.
But the fact remains that most of many fund managers' holdings are not held to deliver performance. They are held for a range of reasons that primarily serve the fund managers' own business interests.
- Many stocks are held for diversification purposes, acting to reduce portfolio volatility and becalm flighty investors.
- Others may be held in order to act as a liquidity service to investors that regularly need to redeem their shares.
- But most of all, the fee-based compensation structure of the fund management business encourages asset gathering - and those assets have to be invested in something, even if it means they can't be invested in good ideas.
Why should lay investors be held hostage to the economics of large-scale fund management? Everything points to the fact that if each fund manager were given a mandate to buy a maximum of 10 stocks, the majority would far more frequently outperform the market. Dare I suggest that enforcing this practice might even create an industry that delivered a market-beating service!
There's an old saying that when you sit down at a poker table, if you don't know who the sucker is, you are the sucker. So if you have to be an investor in funds, find and buy highly focused conviction funds and accept some volatility for the reward of higher returns. Alternatively, play back at the large diversified funds which are trying to game you and blatantly steal their best ideas. Do it gleefully, with a spring in your step and a twinkle in your eye.