I don’t imitate the long holdings of hedge fund managers per se, but I am interested in what stocks they are investing in so that I might take comfort in the fact that someone has undertaken a comprehensive analysis of stocks that come up on my Quantitative system, and thinks them worthwhile.
My understanding is that hedge funds report their holdings in the form of 13F filings. These have some drawbacks, a significant one being a delay of up to 6 weeks in reporting positions. If I am to make any use of this information, my view is that I need to identify what type of fund I am looking at because:
- If momentum trading motivates the manager, then my following into a position with a 6-week delay is rarely going to be consistently profitable.
- If the manager is active with small over/underweight positions around an index, then it is likely that my returns will be about index.
- If the fund manager really adds value through particular insights and good research, then a 6-week delay might not be such a bad thing with one caveat; I do need to know if/when the nominated portfolio starts to under perform.
I am seeking out performance. Therefore it is only necessary to identify the first and third types of managers. To do this, I put myself back in time, look at circumstances at the time of portfolio formation, and then trace the consequences. For the purpose of this article, I reviewed 2 fund managers to illustrate how I might determine which one to follow.
Backtesting in Stages
I considered stocks that were disclosed around mid December 2010. My first task is to look at performance preceding that time, then performance immediately after and finally performance to date.
Prior to 14 December 2010, the active returns of the selected managers was:
And performance over the past two and a half months to date is:
It is an oxymoron to observe that momentum strategies are based on strongly outperforming stocks. If selected in early October, the Momentum portfolio would have been a winner. However we start in mid December, and as the above graphs illustrate, it is after that time that the disappointment sets in. From time to time, momentum works, but it is not consistent. Value Add exhibits greater consistency.
In evaluating which manager to take note of, my view is that:
- The evaluation should start at multiple random dates as data becomes available.
- There should be consistent alpha generated over the analysis period (I use 3 months), no matter what the starting date.
The interesting aspect of this analysis is that most of the stocks in both the Momentum or Value Add portfolios would be in my buy criteria, and are probably very good stocks. In looking at the different portfolio outcomes, I noted a trend that relates to timing.
Part of my usual analysis is to look at the consistency of a stocks’ out performance over time (because it does vary). This is done by reference to risk ratio analysis. In my view, this makes use of the feature that ratios display boundaries that might be used in identifying possible extremes. It is not an ironclad rule, but!
In the following example, TBI was in the Momentum portfolio and HNT in the Value Add portfolio.
From this analysis, the Momentum fund selected TBI at about the time of maximum relative out performance (historical), while HNT was in the Value Add fund at a relative low point. In the period since March 2009, these stocks have been fairly consistent out performers, but clearly when the ratio hits 0.5, its time to consider reducing, not increasing holdings.
As mentioned earlier, I also want to know if the portfolio is maintaining performance.
To do this, I compare the current distribution of returns to those lagged by a period of a few weeks. This quickly identifies whether the portfolio is picking up systemic downside/upside risk.
In the following graph, the indications are that the portfolio is picking up increased downside over a two-week period, which indicates caution.
We constantly hear that active portfolio management does not work and of instances where fund managers “blow up”. In addition, we have access to myriad portfolios encompassing many investment styles. Cloning the portfolios of successful fund managers is an appealing concept, but it does have difficulties.
This article outlines some of the analysis I undertake to:
- Satisfy myself as to the fund managers’ style and skill.
- Determine where portfolio stocks fit in relation to my risk profile and therefore my interest in buying in.
Determine how the fund might be performing in between disclosures thereby minimizing timing mistakes.
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