Imitation

A version of this article was published in the June 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

"I believe in the discipline of mastering the best that other people have ever figured out. I don't believe in just sitting down and trying to dream it all up yourself. Nobody's that smart."--Charlie Munger

In early 2012 I had some cash in my taxable account I wanted to put to work. I had always wanted to be a shareholder of  Berkshire Hathaway (BRK.B), the stock looked cheap, and it didn't pay a dividend. I bought a couple hundred shares over a few days and kept on accumulating through the year.

In hindsight, it looks like I made a smart move. However, I never fooled myself into believing that I had superior insight into the stock. Yes, I had looked at the financial statements, read other analysts' reports, and even took a stab at estimating its fair value, but my efforts felt hollow. I know what it's like to be good at something, and I know what it's like to be bad at something (many things, actually), and I could tell I was on the bad end of the spectrum.

So, why did I bet big on a single stock? My reasoning was simple. Warren Buffett said the stock was cheap. He had recently repurchased shares, and the board had authorized further buybacks under the condition that price/book was under 1.1. I believed him, so I aped his moves. That was really it.

After following Buffett for years, reading his letters, interviews, and speeches, I was confident he is skilled. Of course, almost everyone believes this, or thinks they do, but relatively few take heed when Buffett offers a juicy tip on a platter. At the 2012 Berkshire Hathaway shareholder meeting, Buffett disclosed that he would "love to buy tens of billions at 110% of book." The market yawned. Berkshire's stock price ticked up a bit, and then fell back, as if the Oracle hadn't lobbed a fat pitch over the plate.

It's possible the market thought Buffett was talking his book. I didn't think he was. Alice Schroeder's comprehensive biography of Buffett, The Snowball, reveals a man desperate to be liked and admired, fiercely protective of his reputation. It's how he obtains sweetheart deals no one else can. Buffett wouldn't jeopardize the golden goose for a pop in Berkshire's price.

So, either the market correctly thought Buffett's pronouncement was meaningless or the market was wrong. I decided the market was wrong. It was the only way I could reconcile my belief that Buffett is skilled with the market's lethargic response to the information he had revealed.

Behavioral economists have come up with an explanation as to why markets underreact to new information: Investors are overconfident and put too much stock in their own opinions. Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam built an influential model of investor psychology on this idea, and the model predicts a wide range of phenomena observed in the markets, including short-term momentum, long-term reversal, high volatility in relation to fair value, and event-based return predictability.(1)

The episode helped convince me that mimicking can be a profitable strategy, one that I'd underutilized to date. It got me thinking about how one could actually profit by systematically copying the smart money.

Here's where 13F filings come in. They are a treasure trove of ideas, long used by professional investors and the center of a cottage industry dedicated to analyzing them. The Securities Exchange Act of 1934 requires that institutional investment managers with over $100 million in publicly traded equities and other "13(f) securities" file their quarter-end holdings with the SEC within 45 days. In theory, picking over 13F filings has two advantages over investing in a fund: First, you can assemble your favorite managers' best ideas; and two, you get a free ride on the enormous resources they devote to finding them.

However, for copycat investing to be feasible, several conditions must be true. Let's look at each in turn.

1) You can identify skilled managers in advance.
Fortunately, multiple studies have found that hedge fund performance is persistent. In a 2009 study, John Griffin and Jin Xu sorted hedge funds on a measure of stock-picking ability computed using each firm's full 13F holdings history.(2) By relying on 13F filings, the study avoids a lot of the selection biases that plague traditional hedge fund databases. The top quartile sorted by this measure continued to earn 4.88% annualized returns attributable to superior security selection. However, the funds were bad at timing styles, which hurt their overall results. The evidence, then, suggests a paradoxical strategy: Mimic the picks of successful stock-picking funds, but underweight their currently favored styles.

Let me go out on a limb and suggest that, as a group, the following investors are skilled stock-pickers: Warren Buffett, Charlie Munger, and Seth Klarman. Other candidates include the managers at Oakmark, Primecap, Sequoia, and Fairholme.

2) The managers' 13F filings contain their true beliefs.
Because 13F filings exclude short positions, debt, and many different kinds of derivatives, they need to be interpreted with care. Managers can own securities merely to hedge another position. Investors can mitigate this issue by focusing on long-biased equity managers.

3) The filings aren't stale.
To be useful, a 13F filing should still reflect a manager's true beliefs, even after 45 days. This excludes frequent traders. I've seen the financial media report the latest top holdings of fast-trading quantitative hedge funds such as D.E. Shaw, AQR Capital, and Citadel.

4) The market doesn't efficiently integrate information contained in 13F filings.
An efficient market would swiftly adjust stock prices to the point where no Johnny-come-lately investor could consistently use data from the filings to outperform. Whether the market is efficient in this regard is the crux of whether a copycat strategy can work for individual investors.

If, like me, you pay attention to Berkshire Hathaway's 13F filings, you've almost certainly noticed how new additions to Berkshire's portfolio experience a pop in prices once its 13F comes out. That's evidence of either 1) arbitragers anticipating further purchases by Buffett or those mimicking him or 2) the market marking up the value of those stocks to account for Buffett's presumably superior information or insight.

I don't think the former story makes sense because any potential buying activity is almost certainly a negligible portion of the total trading volume of the highly liquid large-cap stocks Buffett favors. That leaves us with the more sensible interpretation that the market thinks Buffett can identify undervalued stocks.

If the market is completely integrating Buffett's insight into the prices of the stocks he buys, then mimicking his trades should not lead to consistent outperformance.

According to a 2010 study by John S. Hughes, Jing Liu, and Mingshan Zhang, a strategy that copied Berkshire's 13F holdings at each quarter-end would have returned an impressive 6% annualized alpha from 1980 to 2006.(3) Amazingly, a strategy that copied Berkshire's 13F holdings a full year after disclosure would have produced 4% annualized alpha.

However, though Buffett's star was rising by the 1980s, the study is tainted with the privilege of hindsight. Now that Buffett's picks are widely followed, mirroring his portfolio may not be as profitable. Sadly, Hughes and the others don't provide subperiod returns for the delayed mimicking strategy.

They do provide evidence that mimicking the 13F holdings of other institutions is profitable. They sorted institutions based on abnormal returns of their 13F portfolios for the trailing 10 years. Institutions in the top quintile of historical performance went on to earn 2.4% annualized excess returns, suggesting that markets underreact to the information disclosed in 13F filings of other top-performing managers.

This isn't an isolated finding. In a 2001 study, Mary Margeret Myers, James Poterba, Douglas Shackelford, and John B. Shoven found that copycat funds did about as well as actively managed funds after fees.(4) A 2010 study by Yu Wang and Marno Verbeek found similar results.(5)

Overall, the evidence strongly indicates equity managers can be profitably copied even with stale data. While portfolio-mimicking strategies produce inferior returns before fees, after fees they're competitive with the originals.

Copycat Funds
Two exchange-traded funds, AlphaClone Alternative Alpha ETF and Global X Guru Index ETF (GURU), put these findings into practice. Each quarter, they invest in 13F holdings common among top hedge funds, though their exact methodologies are opaque. They seem to favor long-biased equity managers with strong records. I don't see why these funds can't work.

However, I'm not confident in their black-box methodologies. It's evident from their divergent returns that the details matter--a lot. I'm also not a fan of their fees, which near nosebleed territory: ALFA's expense ratio is 0.95%, GURU's is 0.75%. Copycat funds are compelling only if they're much cheaper than active managers. Finally, their sponsors are small firms, so who knows if these funds will be here five years from now. As much as I like the idea of copycat funds, I wouldn't put my money in either one of these.

The real sin of active management isn't that no one can do it. In fact, before fees, a significant minority of equity hedge funds and mutual funds seem to earn superior returns from skill. The problem is that most managers charge high enough fees to extract all their outperformance and then some, leaving investors with subpar results.

A reasonable alternative to active management is to mimic the top 13F holdings of hedge funds with strong track records. Investors' overconfidence in their own research and analysis suggests markets will consistently underreact to new information released by top investors.

(1) Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam. "Investor Psychology and Security Market Under- and Over-reactions." Journal of Finance, 1998.
(2) John Griffin and Jin Xu. "How Smart Are the Smart Guys? A Unique View from Hedge Fund Stock Holdings." The Review of Financial Studies, 2009.
(3) John S. Hughes, Jing Liu, and Mingshan Zhang. "Overconfidence, Under- Reaction, and Warren Buffett’s Investments." Working paper, 2010.
(4) Mary Margeret Myers, James Poterba, Douglas Shackelford, and John B. Shoven. "Copycat Funds: Information Disclosure Regulation and the Returns to Active Management in the Mutual Fund Industry." Working paper, 2001.
(5) Yu Wang and Marno Verbeek. "Better than the Original? The Relative Success of Copycat Funds." Working paper, 2010.

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