Meb Faber’s Hedge Fund Replication 101

February 03, 2016

Mebane Faber is a widely respected quant who’s also Cambria’s chief investment officer and the brains behind a growing roster of ETFs.

His latest book, Invest with the House, looks into what it takes to clone hedge funds and their managers’ investing style. It’s a how-to guide anyone can follow that sheds light on one of the most opaque investment pockets of the market. It’s also a fun read about colorful personalities in the hedge fund space.

Faber shares here some of his key takeaways from the research. Your latest book looks at hedge fund portfolios and how to clone them. Why the interest in replicating hedge funds?

Meb Faber: In any industry, typically, a lot of the best performers will gravitate toward where they get paid most. You’ll find the best doctors in the best hospitals, the best basketball players in the NBA, and so on.

In finance investing, historically, the best paid investors have been hedge funds. That’s not always the case, and in some areas, there are managers who have fantastic track records who aren’t working for hedge funds, but hedge funds attract a lot of top managers. The idea is that if you’re trying to find the Michael Jordan of investing, historically, they have been in hedge funds. How do you go about cloning a hedge fund? Can anyone do it?

Faber: It’s funny, because there is more than $10 trillion—$15 trillion, perhaps—in mutual funds, and most of that is active mutual funds. So, historically, investors have no problem allocating to active managers and making a bet on that manager or that process.

However, hedge funds have been historically opaque, and only available to rich/accredited investors. They have many headaches with the structure—there’s lockups, liquidity issues, transparency. And because of the advertisement requirements historically, there’s not a lot of information on hedge funds. People may know who Warren Buffett is, and maybe George Soros, but they don’t know who the other 1,000s hedge fund managers are.

The actual tracking of the hedge funds is easy. It takes about five minutes a quarter (we outline that in the book). But it does require a bit of domain expertise in doing due diligence into fund managers. But that’s what the book is about. The way to know what hedge funds are up to is through 13F filings. But aren’t they retroactive in nature? How useful are they in telling you what to do going forward?

Faber: That’s a key question when looking at hedge funds. The good news is that every manager who owns more than $100 million has to publish their holdings once a quarter, but that’s usually with a 45-day delay. Being a quant, I can’t get comfortable with your question until it has been answered, and no one has ever answered this question, which is why I started doing this research, looking at 13F filings by hand for a dozen or so managers.

I looked at all the SEC filings and stock databases, and it took about six months to do, but I found out that, first, it works. You can see what they are doing. Second, you have to follow the manager’s process, and derive their value from their long-only holdings since shorts and derivatives don’t show up. The classic example here is Warren Buffett, who has said his ideal holding period is forever. That’s the type of manager you want to follow.

But one key point here is the ability to stick to the manager’s style despite business and economic cycles. Even Buffett has had periods of underperformance, but he always stuck with his style of buying value, high-quality companies. Chasing performance of fund managers and styles is usually detrimental to the portfolio. 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. 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. 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. 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. 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. 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].

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