Why Stephen Taub is Dead Wrong About Following Hedge Funds’ 13F Filings

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BERKSHIRE HATHAWAYHere at Insider Monkey, we're big believers of imitating the smart money. Over at Institutional Investor's Alpha, Stephen Taub penned an article titled "Beware the Temptation to Follow Hedge Funds' 13F Filings." We're going to show you why he's dead wrong.

You can beat the market following hedge funds' 13F filings, and we'll show you how.

In the article, Taub breaks his argument into three parts; we will deconstruct each.

Taub's First Argument: Hedge funds' most popular stocks performed terribly since September. This means that it's not always a good idea to mimic their top picks.

In his analysis, Taub mentions that "the hedge fund set is not always so brilliant," adding that "three of the four most widely held stocks lost money from October through December." These are Apple Inc. (NASDAQ:AAPL) (-20.2%), Google Inc (NASDAQ:GOOG) (-6.3%), and Microsoft Corporation (NASDAQ:MSFT) (-10.3%).

He's wrong because: You can always find a time period where any investment strategy underperforms.

It's no secret that some of tech's biggest names have been struggling over the past few months; you'd have to be living under a rock to miss daily news of Apple's fall from above the $700 mark. But let's be clear: any investor owning this trio of stocks for the entirety of 2012 would have come out in the green. Apple returned over 30%, Google was up 9.5%, and Microsoft gained 2.9%.

Our main point, though, is that in order to test any investment strategy, an actual empirical analysis must be done, and the time period must be much larger than simply three months. We did one, and the results speak for themselves.

We have 10 years of 13F data for 92% of all hedge funds between 1999 and 2009. The 30 most popular picks among hedge funds generated a positive alpha of 10 basis points per month (see the details here). This means that on a risk-adjusted basis, hedge funds' most popular stock picks outperformed the market by around 1 percentage point per year over the 10 years we analyzed.

Taub's Second Argument: There is a 45-day delay in reporting, and hedge funds' portfolios might change significantly. He assumes that you cannot beat the market because of this delay. He also assumes that you cannot replicate hedge funds because of this delay.

He's wrong because: This delay actually helps investors' ability to beat the market by imitating hedge funds.

Once again, there's no shred of empirical evidence behind Taub's argument. He makes the assumption that hedge funds are great at timing the market, and if you imitate their 13F holdings with a 45-day delay, you'll get burned.

This isn't true.

In fact, hedge fund managers can't always perfectly time the market. If they're early into an investment, then imitating them after a 45-day delay might yield even better results. We can prove that this is the case.

In our original analysis, we also used a 2-month delay in our backtest of hedge funds' 30 most popular picks. We found that between 1999 and 2009, these most popular stocks generated a monthly alpha of 19 basis points (more than 2 percentage points per year). Our results got even better.

Above, when we imitated hedge funds with no delay, we generated an alpha of 10 basis points per month; in practice this isn't possible. With a 2-month delay, we improved our performance over hedge funds by 1 percentage point. We beat hedge funds by 1 percentage point per year, and the market by 2 percentage points.

So, both of Stephen Taub's assumptions are wrong. It is a good thing for monkeys to have to wait 45 days to see hedge funds' portfolios.

What's the lesson here folks?

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