ETF.com: Can you do it with ETFs or do you have to do it with individual securities?
Faber: You need to use individual securities. But you can do this two ways. One, you can use the filings as an idea farm. What is David Einhorn buying? What’s Buffett buying that maybe warrants further research?
Or two, you can use it as a way to outsource your portfolio and buy five or 10 stocks from your favorite managers and run it as your hedge fund of funds. There are a number of benefits involved with that approach, but primarily you get transparency, better tax management in your portfolio and you can control fees.
Hedge funds typically charge 2% management fee and 20% performance. It’s a monster hurdle. The hedge fund has to return something like 18% just to get a 10% net return after fees. In many cases, tracking these hedge fund portfolios outperforms the hedge fund itself because of fees.
ETF.com: You’ve also found that equal-weighting a hedge fund’s top picks often outperforms the manager's own weightings. Why?
Faber: We found that equal weighting versus how the manager actually weights the securities in the portfolio across the board doesn’t really matter. But we thought equal weighting a list of managers’ top picks was an easier approach for investors to do and not have to worry about screwy percentages and rebalancing, and all that.
But going back to 2005, we realized that it’s often that the top stocks (percentagewise in a portfolio) that people perceive as being the hot idea. This manager has 20% into this one stock, this must be the best idea.
Typically, it turns out that’s not the best-performing position out of the top 10 or 20—it’s actually the worst. It became the top holding because of appreciation, and by the time it’s at the top, the stock has already gone up. Factor in a 45-day delay in reporting that position, you’re probably buying a stock that merely appreciated rather than the best idea.
We suggest in the book that investors should exclude the top position, and buy positions two through five or two through 10 and do even better. The caveat to that—and one of the dumbest things you can do—is buy the most popular stock across the entire hedge fund universe. You are buying a stock that a lot of managers own, and it carries a lot of risk in a downturn.
ETF.com: So the easy recipe to replicate a hedge fund is pick a manager you like, look at 13F filings, pick the top two to five or top two to 10 holdings, and equal-weight them?
Faber: That’s a good way to do it. But the idea is to pick your manager and let them go anywhere. Don’t second-guess their decision to, say, buy airlines at a certain time in the cycle. Once you start second-guessing the managers and add additional screens—only going to buy, say, small-caps—you’re drawing away from what the strategy is.
ETF.com: What about hedge fund replication ETFs such as the Global X Guru (GURU | B-62) and the AlphaClone Alternative Alpha (ALFA | C-37)? What’s your view on how well this type of strategy works in an ETF wrapper?
Faber: Theoretically, the strategy should work great. And for full disclosure, I own a very small equity stake in AlphaClone but have had only a passive involvement with the company for many years. So, the ETF structure is just a structure, so it should work. I can’t comment on how either of those strategies really work because their methodologies aren’t fully disclosed. If you read their documents, neither says exactly what they are doing, so I’m not aware of exactly what they are doing.
ETF.com: Any other takeaways?
Faber: The hedge fund space has a lot of personalities. Once you read about them, you start to appreciate how much time, effort and resources they put into studying these companies. It’s fun to see what these guys are doing.
ETF.com: Should we expect to see an ETF linked to this latest research anytime soon?
Faber: We are always coming up with new ideas. We have two new funds coming to market next month—an emerging market one, and a sovereign global bond fund—and we have another filing coming up. We have a couple of other ideas we’re working on. But we’re going to settle down to around eight to 10 funds.
Contact Cinthia Murphy at [email protected].