Be Careful Following This Investment Professional's Advice

Includes: BRK.A, BRK.B, GS, SPY, TBT, TLT
by: The Financial Lexicon

If you spend enough time following the financial markets, you may be accustomed to the fact that the media likes to build up certain investors as all-knowing sages. In the world of stocks, one such person is the "Oracle of Omaha," Warren Buffett. In the world of bonds, there is the "Bond King," Bill Gross. But just because a person may be known as a leading figure among investors does not mean you should blindly follow that person wherever he or she may go.

During the financial crisis of 2008, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) invested roughly $5 billion in Goldman Sachs (NYSE:GS). For that investment, Berkshire received perpetual preferred shares paying a 10% dividend. Additionally, it received warrants to buy $5 billion in common stock at a strike price of $115 per share. If Warren Buffett followers wanted to jump on board the Buffett-Goldman Sachs Express in 2008, do you think any of them would have gotten that type of deal?

The chances are quite good that most investors would have purchased the common stock, which traded between $113.01 and $125.95 on the day the deal was announced. Recently, Goldman Sachs' stock closed at $117.91. Let's call that unchanged over the past four years (with a whole lot of volatility in between). The S&P 500 (NYSEARCA:SPY), however, is up more than 20% since the Berkshire-Goldman Sachs deal was announced on September 23, 2008. If you followed Buffett into Goldman Sachs by purchasing the common stock (rather than getting the amazing deal Berkshire Hathaway got), that investment has underperformed over a four-year period. But perhaps things will work out over the undefined "long-term."

In 2011, I lost track of how many times I read about Bill Gross' dumping Treasuries from PIMCO's Total Return Fund and generally being negative on U.S. debt. A March 9, 2011 Bloomberg article titled "Pimco's Bill Gross Dumping Treasuries Leads Managers Calling Rally's End" was published when the 30-year Treasury was around 4.60% and the 10-year Treasury was trading around 3.50%. The 30-year and 10-year Treasuries were recently yielding 2.81% and 1.61% respectively. In terms of Treasury ETFs, the popular iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT) was actually trading under $90 on March 9, 2011 on its way to $132. Everyone makes mistakes, but when you are the "Bond King," and you miss a rally in Treasuries like the world witnessed in 2011, that is especially bad.

While it is usually impossible to say with 100% certainty whether you will lose money by emulating your favorite professional investor, if you discover the odds are overwhelming that you will, then stay away. This leads me to a current example of a professional money manager, highly touted over the years by CNBC, who may not even realize he is likely on the wrong side of a trade.

Doug Kass of Seabreeze Partners Management is someone I enjoy watching when he makes an appearance on business television. It is not because the well-known short-seller called the bottom in the stock market just days before it occurred in 2009. Rather it is because his insights often provide a breath of fresh air to business airways clogged with segments lacking insight.

In recent weeks, Kass made two very public market calls: one was to short Treasuries, and the other was to short stocks. Given the fact that intermediate- to long-term Treasury prices have generally exhibited relatively strong negative correlations to broad equity market indices over the past decade, it is hard for me to imagine how he can be right on both trades.

One way to confirm the negative correlation on the long end of the Treasury curve is by looking at the iShares Barclays 20+ Year Treasury Bond Fund's beta, currently a negative 0.30. The negative beta implies a negative correlation between the long-bond and the broader stock market. This means that as one goes up in price, the other generally goes down in price.

Buying intermediate- to long-term Treasuries has actually been a great way to express a short position in stocks. Unless correlations change, if you are shorting stocks and shorting intermediate- to long-term Treasuries, you are actually putting on two directionally offsetting trades. This makes it impossible to make considerable money on both positions at the same time.

If equity markets continue higher, my hunch is that Treasury yields will remain near where they are today or go higher (lower in price). In that case, Kass will win on his Treasury trade and lose on his equities trade. If equity markets head lower, I suspect Treasury yields will decline (rise in price), meaning Kass will lose on his Treasury trade but win on his equities trade.

While Kass has some compelling reasons for each of his two positions (shorting equities and shorting Treasuries), unless you believe correlations are about to change, investors should not follow him into both of these trades. I suppose investors wanting to lock in gains before tax rates possibly head much higher next year might sell off both stocks and bonds simultaneously in Q4 2012. But I would not structure a portfolio around that possibility. Or perhaps the fast-approaching debt ceiling will bring about a default on Treasuries causing both stocks and bonds to spiral downward. While a Treasury default can never be completely ruled out, it is not one of Kass' reasons for putting on the short positions.

If you do decide to follow Doug Kass and short Treasuries and equities at the same time, you will need to think long and hard about how exactly to make the bet on the Treasury allocation. Buying a leveraged ETF such as the ProShares UltraShort 20+Year Treasury (NYSEARCA:TBT) can work for shorter periods of time. But if you are attempting to short Treasuries for any longer period of time, leveraged ETFs are not the type of product you want to use. As ProShares explains on its website, "Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period."

Should you decide to focus on intermediate-term Treasuries and short the 10-year Treasury directly, you will want to be aware of the effects a steep yield curve has on prices. Shorting intermediate-term Treasuries for an extended period of time when you know the Fed is keeping the front end of the yield curve near zero for several more years seems like far too much trouble for the effort. Surely there are better trades to be found from a risk-reward perspective.

While it may be tempting to follow professional investors with a history of success into whatever investments they see fit, remember that even the best investors in the world will be wrong at times. And when trying to emulate Warren Buffett, remember that he can get deals on his investments that the rest of us can only dream of.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long a number of individual equities and bonds (corporates and Treasuries), although none mentioned in this article.