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.

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