Tailgating the Top Fund Managers: Risky Business

Andrew Bary in Barron’s takes a look at the top holdings of five prominent hedge fund managers as a means of generating a worthy list of investment candidates (Seeking Alpha summary here). This sort of exercise is a staple of the financial media. With some appropriate caveats, like the time-lag involved between filing, Bary writes:

By looking at the top holdings of some top managers, investors can put together a best-ideas portfolio without paying management fees. Most of the largest and best-run hedge funds are closed to new investors, and even if they were to open their doors, fees can be steep. Hedge funds generally carry base management fees of at least one percentage point and typically take 20% or more of profits.

John Bethel at Controlled Greed weighs in on the article as well noting that this process of scanning the holdings of top managers is widespread among professional (and amateur) investors alike and is “… an excellent tool in finding investment opportunities.”

We would agree, in general, to this sort of approach. However investors should be somewhat more wary when examining the holdings of hedge funds for investment ideas. The very nature of a hedge fund is that it allows for greater manager flexibility. Therefore large holdings may be offset by short positions in similar stocks or hedged by derivative securities not among the fund’s top listed holdings.

Closely monitoring the holdings of fund managers, hedge or mutual, is not unlike tailgating. That is following the car in front of you too closely, as opposed to the pre-game meal served prior to a football game. Tailgating behind a great driver could get you to your destination a little faster.

However, tailgating is also a large contributor to auto accidents. Tailgating deprives the trailing driver with vital information on the road ahead. Relying on the driver in front of you is at best an iffy proposition.

No one proposes that one buy slavishly the top holdings of favored investment managers. Indeed these investment ideas need to be researched, vetted and in an important sense needed to be “owned” by you before any purchase. In a time of freer (and faster) information flows the sources of investment ideas is constantly expanding. On the other hand, as investment processes become more complex the interpretation of that information also becomes less transparent.

In short, investors need to have in place a research and portfolio management process that works for them, no matter the source of the original investment idea.