Posted by on Nov 23, 2015 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig | 2:38 pm ET  Nov. 20, 2015

Call it “the year of mimicking dangerously.”

A handful of mutual funds and exchange-traded funds seek to emulate such leading investors as hedge-fund manager William Ackman of Pershing Square Capital Management. Most of these funds are down 5% or more for 2015, and some have lost at least 10% over the past three months as the embattled drug company Valeant Pharmaceuticals International and other holdings of top investors have tumbled.

Imitating great money managers can be risky and requires plenty of patience. And leaning on someone else’s smarts doesn’t exempt you from the responsibility of doing your own thinking.

But why wouldn’t you want to own the same stocks as the world’s most successful investors? Even in the 19th century, speculators desperately sought “points,” or tips on what market titans like Cornelius Vanderbilt or Jay Gould were buying.

And Pankaj Patel, a quantitative analyst at Evercore ISI, the investment-research firm, reckons that the top 10 holdings among elite, highly focused funds have outperformed the S&P 500 by an annual average of 10.4 percentage points over the past four years.

“I have some of the most brilliant people in the world doing my security selection,” says Ken Squire, manager of 13D Activist, a $400 million mutual fund that buys into a select group of undervalued companies being shaken up by influential investors. His fund is one of only 4% of actively managed U.S. stock funds to outperform the S&P 500 in 2012, 2013 and 2014.

But 13D Activist is down 10% over the past three months as many stocks favored by activists “have gotten killed,” says Mr. Squire. Such companies tend to get hit harder in market declines, he says, because investors often seem to own them mainly because famed activists like Carl Icahn or Mr. Ackman do. Lacking the courage of their own beliefs about these stocks, many investors bail out at the first sign of trouble.

AlphaClone Alternative Alpha is a $143 million ETF that selects at least 20 hedge funds it believes to be especially skillful and builds a portfolio of about 75 stocks from among their top holdings. AlphaClone limits its largest position to 15%, and its 10 biggest holdings can’t exceed 50% of assets. The fund also sometimes hedges against the risk of a deep market decline by short-selling, or betting against, the S&P 500.

“We think it’s a very thoughtful way of selecting, evaluating and aggregating high-conviction ideas into a portfolio,” says Maz Jadallah, president of San Francisco-based AlphaClone.

Over the three years ending Sept. 30, the fund returned an average of 13.3% annually, while the S&P 500 gained 12.4% including dividends.

Unfortunately, by then Valeant had grown to be the fund’s largest holding, at 7% of assets. At the end of September the fund’s hedging formula kicked in — right before the S&P 500 shot straight up the following month. October was the worst of both worlds for the fund as it captured Valeant’s 47.4% decline but missed out on the stock market’s 8.4% gain.

The hedging strategy has worked most of the time in the past, says Mr. Jadallah, and is meant to “protect against the permanent destruction of capital.”

Global X Guru Index, a $176 million ETF, tracks the biggest holdings of a group of prominent hedge funds, then selects about 50 of them for the fund. Through the end of June, the fund gained an average of 21.2% annually over the previous three years, while the S&P 500 returned 17.3% annually. But Guru lost 11.7% in the third quarter as top holdings Horizon Pharma, Depomed and other drug companies took a simultaneous pounding.

Bruno del Ama, chief executive of Global X Funds, wasn’t available for comment.

You shouldn’t buy a stock “just because Warren Buffett or another smart investor bought it,” says Robert Hagstrom, who used to run a fund that sought to emulate Warren Buffett’s stock-picking methods without copycatting him identically. (Now called ClearBridge Global Growth, the fund pursues a different strategy today.) “You’ve got to have your own thesis as to why you own it,” he says.

As the guru funds have recently shown, great investors’ bets don’t always pay off — and often flop together. For that matter, many investors who seemed great may turn out to have been merely lucky.

So, says Mr. Hagstrom, if you do follow smart investors, then diversify widely. That way, he says, if one or a few of them “make an unforced error, it can’t slam your entire portfolio.”

Of course, once you track a dozen or two smart investors, your portfolio will start to resemble the stock market as a whole — which you can buy more comprehensively, and much more cheaply, in the form of a total stock-market index fund. Do it through a guru fund, and you still can’t diversify away all the risks.

Picking market-beating stocks is hard. Picking the people who can pick market-beating stocks is at least as hard. And picking funds that can pick people who can pick market-beating stocks may be the hardest of all.

Source: The Wall Street Journal