3 Ways Mimicking Hedge Funds Can Actually Hurt Your Investment Portfolio

A very popular trading strategy among retail investors is to mimic what famous hedge funds are doing. Most large hedge funds report a summary of their portfolios in 13-F filings, and an average Joe can easily discern what hedge funds are trading based on these documents. However, basing your entire investment strategy on these 13-F filings can actually be a dangerous exercise. Here, we discuss 3 of the most significant reasons why blindly following 13-F hedge fund filings can mislead retail investors, and what they can do to alleviate these downfalls.

Significant time delays

First and foremost, the most obvious reason why 13-F filings can be misleading is temporal in nature. For instance, these 13-F filings are meant to represent which stocks a fund is holding on the last day of each quarter: 31 March, 30 June, 90 September and 31 December. However, these reports aren't typically made available to the public for more than 30 days, which is often after most stocks have reported their quarterly earnings. Such a long time lag can easily mislead retail investors because quarterly earnings can significantly alter a fund's view about its portfolios. This means that, by the time a retail investor decides to buy a certain stock because his favorite fund owned them, the said fund could actually be selling it.

For example, let's say few famous funds' 13-F filings indicated that they owned a hypothetical stock called ABC as of 30 September. However, ABC's stock declines by 20% between 30 September and 31 Oct after ABC reported losing a significant customer that will massively reduce its income. This is where blindly following 13-F filings can be very dangerous: seeing the 13-F filings on 6 November, an average Joe may decide to purchase the stock believing that he is able to buy ABC's stock at a bargain compared to what those hedge funds paid, without realising these funds were actually wrong. For itnerested readers, here is a well documented example of this from the real world.

Difficulty in discerning new long positions from short covering

Another pitfall of blindly following 13-F filings is that they don't accurately represent what hedge funds are actually doing. For example, 13-Fs don't capture short selling activities, in which portfolio managers bet against a stock. To short-sell a stock, a fund has to first borrow the stock, sell it and then repurchase the stock at a lower price in order to repay its lender. Therefore, it's actually difficult to discern from a 13-F document if a stock purchase indicates that the fund is optimistic about the stock's future or that it is no longer pessimistic on it. In other cases, a fund could have actually "sold out" of a position by purchasing put options without actually selling its stock. There many potential motivations for doing so, including reducing tax as well as maintaining relationship with company CEOs. In this case, an average investor may be mislead to believe that his favorite fund is still optimistic about a stock, while the truth may not be farther from the truth.

Limited visibility on international stocks

One last downfall of following 13-F filing is its limited exposure to international stocks. Because most 13-F filings exclusively report on hedge fund's stock ownership in the US, outside observers actually can't see what these hedge funds own in other countries. This weakness is especially relevant for investors out in Asia who actively want to invest in companies that they are more familiar with.

Solution: do your own homework

Despite these shortcomings, studying hedge funds' 13-F filings does have some real merit. As long as you are aware of the issues discussed above, you can use these filings to look for new investment ideas that you can research. In our view, the best way to use 13-F filings is to pick a few hedge funds with a very long-term investment horizon, and to narrow down their biggest holdings and biggest trades to inform what you want to research next. Before you buy a stock, you should always have built a good understanding of what factors drive a stock's fair value, and what potential risks may exist in your investment. While it can be daunting to do so with hundreds of stocks to research, starting your journey with a shorter list handpicked by the best professional in the world may not be way to start investing.

Duckju Kang

Duckju (DJ) is the CEO of ValueChampion. He covers the financial services industry, consumer finance products, budgeting, and investing. He previously worked in the financial services industry, including at such hedge funds such as Tiger Asia and Cadian Capital. He graduated from Yale University with a Bachelor of Arts degree in Economics.

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