How you can beat fund managers by cloning their best ideas

It’s increasingly common knowledge that actively managed funds significantly underperform the stock market. The level of underperformance varies in different market cycles but on average it is of the order of 3% per year. Given this, is there really any point in paying attention to what fund managers are buying?

Well the latest cutting edge research shows that there is. Fund managers are actually way better stock pickers than these numbers suggest. By separating the wheat from the chaff in their bloated portfolios you can find their very highest conviction ideas… ideas which dramatically beat the market, by up to 20% per year!

So what are a fund manager’s ‘best ideas’?

In hunting for their best ideas the first place to look would be amongst their top 10 holdings, but this would be naive. A fund’s performance is normally assessed relative to a benchmark index like the FTSE 100. If a fund underperforms this index the investors often pull out their money and the fund manager can lose his job.

So to manage this career risk, the cautious fund manager often weights most of the stocks in his portfolio similarly to the benchmark, with proportionally larger weights in the stocks weighted more heavily in the benchmark. It’s only for his very best ideas that he’ll deviate these weightings most substantially.

Indeed a ground breaking 2005 research paper called “Best Ideas”, Randy Cohen, Christopher Polk and Bernhard Silli researched this common sense idea. For every fund in the market, they calculated the deviation or ‘tilt’ of each holding from the benchmark weight. Portfolios constructed using the top 25% highest conviction positions held by fund managers showed anywhere up to 23% excess annual returns depending on the technique used!

How can you maximise the returns from high conviction fund manager ideas?

We won’t go into the precise technique used in the paper as it’s beyond the scope of this article, but there are several key findings from the paper which can significantly improve the results from cloning best ideas:

1. Stick to each manager’s top pick — The stock with the very highest ‘tilt’ for each manager outperforms the rest of their picks. Descending down the rankings through the second, third & fourth best ideas ‘monotonically’ reduces returns. When assessing the strength of a fund manager’s idea it’s worth bearing this in mind. Anything outside the top five best ideas is unlikely to be a high conviction idea. By the tenth idea there is very little value. Why these guys often have 100 stocks in their portfolios is beyond me !
2. Stick to each manager’s freshest, best picks — Intuitively the newer or ‘fresher’ an stock idea the better. Filtering further to highlight just the conviction holdings that are being bought or added to can increase returns by several % per year.
3. Stick to ideas not shared by other managers — Amazingly, the performance is best when no other fund manager shares a stock as their best idea. This doesn’t get in the way too much though given that ‘more than 70% of best ideas do not overlap across managers, and only 8% of best ideas overlap over 3 managers at a time’.
4. Overweights in risky stocks are more significant — Dramatic improvements to profits were found by adjusting the rankings of each stock in the list by it’s share price volatility vs the benchmark. This makes sense when you realise it’s the job of a fund manager to smooth returns. They will only overweight volatile stocks if they are convinced there is value there.
5. Stick to the very highest tilts — While the paper generally focuses on the top 25% of best ideas across the fund manager universe, far greater returns can be generated by focusing on the very best 5% of ideas which outperform by up to 23% per year. This has promising implications for individual investors who should be able to piggyback these very best ideas more nimbly than larger investors.

In simple terms there is a huge amount of alpha in cloning the best, freshest, unique ideas of each fund manager.

How long does the outperformance last for?

A simple buy and hold portfolio of these best ideas continues to outperform month by month up to 12 months after the portfolio is constructed. While much of the outperformance to mimicking insider (director) buying occurs within the first month or two, the outperformance from fund manager’s best ideas occurs more persistently across an entire year, giving plenty of time for individual investors to get in on the ride.

Written by Edward Croft, CEO at Stockopedia.

Originally published at www.stockopedia.com.

Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.