BRK.A Berkshire Hathaway Inc

By James Mackintosh 

Douglas Adams had a wonderful way to navigate in the days before GPS: the author's hapless detective Dirk Gently would simply find a car which looked like it knew where it was going, and follow it. Most investors are lost most of the time, and a surprising number follow the Douglas Adams strategy: imitate someone who seems smarter.

The sheer amount of money behind such copy-and-paste strategies was on show this week when Berkshire Hathaway revealed it had bought $1 billion worth of Apple shares in the first quarter. Berkshire chairman Warren Buffett is widely regarded as one of the smartest investors of all time, and his acolytes--and plenty of others--follow his holdings obsessively.

Not just obsessively: fanatically. The news added $18 billion to Apple's market value on Monday. Apple's market capitalization increased as much as the next five biggest gainers in the S&P 500 combined.

Copying Mr. Buffett makes some sense, assuming it was indeed Mr. Buffett who made the investment, not one of his two deputies charged with running big investment portfolios. He is a (very) long-term investor with a good eye for quality companies that tend to do well over time.

Mr. Buffett may be more famous than most, but the portfolios of the leading hedge funds, disclosed in regulatory filings known as 13-Fs, attract significant attention, too. A mini industry has grown up online allowing investors to track what the hedge-fund stars are doing, and imitate their financial heroes. Investment banks are also in on the game: several have created indexes of the shares the big hedge funds prefer.

But academic evidence shows investors should be cautious about simply trying to mimic what hedge funds are up to. For starters, the information is imperfect. The 13-Fs show only U.S. shares the funds have bought, or taken options on. They ignore short bets, foreign stocks, bonds and futures. They are delayed by up to 45 days (Monday was the deadline), giving agile hedge funds plenty of time to change their mind and dump a stock. And about a third of their holdings are missing entirely, as they ask the SEC for permission to keep them secret.

The past year's pummeling of crowded hedge-fund trades suggests that at times it pays to do the exact opposite what the supposed "smart money" is up to.

Start with the good news: Shares do indeed go up after big-name managers disclose positions. But the effects wear off quickly, or are small. Research this week from S&P Global Market Intelligence shows that buying stocks in which the biggest hedge funds had increased their holdings most, and selling those they cut back the most, would have slightly beaten the market. But the effort involved for a 0.22% average outperformance of the market over the following month, before trading costs and tax, really isn't worth it.

Academics have previously found a more significant two-day effect, but that is for fast-moving day traders, not investors. Over a month, a study a few years ago by Stephen Brown of New York's Stern School of Business and Christopher Schwarz of the University of California found no impact from 1999 to 2008.

Tweaks can improve the figures. Taking just the "best ideas" of the biggest hedge funds--the stocks they hold the most of--returned an extra 0.49% over a month, according to S&P. Nice to have, but hardly a way to Buffett-style riches, given there are only four chances a year to try this out.

The bad news is that these small gains are interspersed with giant losses. Hedge funds rushed for the exit this year as their biggest holdings began to fall, and their selling made them fall even further. A Goldman Sachs equal-weighted index of the most popular 50 stocks held by hedgies plummeted 16% in the first six weeks, while an equal-weighted version of the S&P 500, also calculated with dividends reinvested, lost only 11%. Since the index was created in November 2007, the S&P has provided a better return than the top hedge-fund picks.

More embarrassing still for the smartest guys in the room is that the stocks they were betting against -- or Goldman's proxy for them--rose far more than the hedge funds' favorites, and slightly beat the market.

It is easy to bash the stock-picking skills of hedge funds (Valeant, anyone?). Much worse is the tendency of hedgies to crowd into the same stocks, pushing up prices and making them all look like geniuses, until they all head for the door at the same time.

The 13-F filings can be very useful for spotting the moments when hedge funds are all copying each other. That is the time to worry that any upset might see a violent exit crush the crowded trades. At other times the best ideas of the smartest managers, at least those who don't trade too frequently, make a good starting point for investors. But be warned: there's no substitute for doing your own analysis.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

May 20, 2016 09:23 ET (13:23 GMT)

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