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How to create a hedge fund portfolio that beats the market (checklist)

Posted on January 19, 2012 at 1:43 pm

In Tradestream your Way to Profits, I wrote about how smart investors can use hedge fund filings to create a wining portfolio. By tracking the holding information of some of the most successful investors on the planet, individual investors can piggyback on hedge fund returns.

Many in the media — including some people I believe are smart, intelligent investors — poke holes in these replication strategies.  I’m not sure of their motivations, but the data are clear: By methodically creating a portfolio that seeks to mimic specific hedge funds (not all are good candidates for replication), individual investors get a big piece of the returns many of these funds have generated for years. Here’s a webinar I hosed last year on the subject of cloning hedge funds.

My ‘hedge fund’ portfolio

I’ve been developing a Tradestreaming.com Guru Portfolio this for the past couple of years (testing for 1 and using it with client funds for 2). While the S&P 500 was essentially flat last year, my Guru Portfolio generated close to 6% before fees. Even more impressive, it’s up close to 190.3% over the past 3 years with a 13.4% drawdown.

AlphaClone has been indispensable to building this portfolio (that image is from AlphaClone). I wrote about how AlphaClone is the cure to investor insanity in 2009 and I still believe it’s a very important tool for all investors to build tested, defined strategies that build on the research done at the world’s top hedge funds.

The point here though is that just buying a stock willynilly that Carl Icahn is targeting on a buyout or that Warren Buffett just put $1B into, isn’t really a strategy. For hedge fund replication to really work, you need to spend the time understanding how certain funds can best be piggybacked.

There needs to be a method to the strategy for this to really work — one that removes and individual’s decision making (ah, I like this stock OR, nah, I wouldn’t buy that — it’s a dog!) throughout the process. I found this to be the hardest part of implementing this quasi-quantitative strategy.

How to build a custom piggybacked hedge fund portfolio

There are simpler strategies on AlphaClone that are just plug-and-play, no research needed. You can see 6 different ways people are tracking hedge funds which don’t require a ton of work. Some of these work amazingly well, but I personally wanted something customized to some of the things I’m working on at Tradestreaming.

Here’s how I built my Tradestreaming Guru portfolio and how you can begin doing it in just under 1 hour with AlphaClone.

1. Understand how funds can be tracked: Some funds are hard to replicate. From what I’ve seen the best funds to piggyback hold positions for at least a few months at a time, have a value approach, and don’t have a problem taking big swings on individual stocks (meaning, have a sizeable % of their assets in individual names).

*Important point: Sometimes (and AC helps here, too), it’s not an individual fund’s picks that are the most exciting. Instead, it’s the most popular stocks held by a family of funds (say, the Tiger Cubs). Or, the most popular (that’s its technical name) stock in a certain industry or market cap held by all hedge funds (say, technology or transportation).

Here’s a list of the most tracked funds on AC to get you started (though AlphaClone literally tracks thousands of funds):

alphaclone

2. Determine what your ideal portfolio looks like:  If you look at the list above, these funds perform pretty damn well (at least at the 3Y mark), but their clones are portfolios comprised of the funds’ top 10 holdings. If you tracked a handful of these funds, you’ll end up with a pretty large portfolio of individual stocks.

Before you begin, it’s important to envision what type of portfolio you want:

  • Do you want to design a portfolio of 100 positions or 10? 
  • Are you comfortable following picks from just one hedge fund or do you want more diversity?

I personally didn’t want a portfolio larger than 10-15 stocks (read below).

3. Determine which strategy will get you to your ideal portfolio: When you play around on AC, you’ll see that certain funds are best replicated by a strategy that buys their top 10 holdings. Others work better by just following the top holding. Still, some follow the newest holding.

I wanted an easy-to-manage portfolio of  about 10 stocks (to get diversity and focus on different sectors) and I didn’t want a portfolio of 100 stocks (10*10). Instead, I targeted funds that worked well by just buying their top or newest holding. If I’m following 10 funds, that would leave me with a 10 stock portfolio (1 stock from each fund).

4. Screen, screen, screen

I used AC to screen for funds that:

  • performed well
  • had high Sharpe ratios
  • lower drawdowns
  • I looked for returns over 3 to 5 years
  • and that replicated well by using a single stock pick to represent their returns

I was also looking for funds that had focuses on different sectors (like biotech or tech or small caps, for example).

5. Add these funds to a Fund Group

As you find the funds that fit your strategy, add them to what AC calls a Fund Group.

Once you’re logged in to AlphaClone, go ahead and click the Create a Clone Group button under the Your Custom Groups tab. The feature can be used to combine and filter a group’s holdings by sector and/or market capitalization then backtest performance.

Before we checked how each individual clone performed over time. Now, with a group, you can see how the whole portfolio performs. You can add or subtract funds to get your portfolio right.

I settled on a strategy that tracked 9 different funds. I’d suggest a portfolio that has more holdings in it. Occasionally, the funds I’m tracking held the same stock (Apple $AAPL was everyone’s favorite in 2011) and that meant I had few positions and the portfolio fluctuated more than I would have liked.

6. Rebalance quarterly

AlphaClone updates every quarter, a month after hedge funds file. You’ll see what was bought and sold and you can make any changes in your real-money portfolios based on the new names in the portfolio.

Creating a piggybacked portfolio works — both in practice and in the research.

Will it continue to work? Who knows, but like tracking insider trading, it makes sense that it should and AlphaClone is essential to doing this the right way.

Was this helpful? Let me know in the comments.

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  • Sh*t investors say

    Posted on January 25, 2012 at 1:35 pm UTC

    I know, I know…It may be trite but I thought it would be a fun post to write.

    Sh*t investors say

    1. “I want to turn $100k into $5 million”: Possible? Yes. Likely? No. It’s a real discussion going on on Quora now. The best way to grow a portfolio is by continuing to add to it (even better if your employer can match — that’s free money). To get 75% compounded returns, I personally like the answer to buy a $7 million life insurance policy and have an “accident”.
    2. “But Suze Orman says to…”: I hear this one a lot. It’s best not to have gurus. Not Suze. Not Dave. Not me. These guys are great to learn from. Go ahead and glean. The good ones are great teachers and offer great learning opportunities. But they’re out to build their own businesses. And as we’re learning in SuzeOrmanGate (my term), they’re liable to sell you stuff that’s just not good for you. I’m not picking on Orman — she’s done great things for people. But gurus are human and stumble sometimes.
    3. This investing stuff is easy”: No, it’s not. Sure, clicking buy or sell on your online trading account is pretty simple but the act of investing — planning, risk management, asset allocation — is hard. At least just for the fact that much of the process requires us to fight against our natural, human inclinations.
    4. “This strategy is a printing press — it always works”: Strategies work until they don’t. Many strategies, like my hedge fund piggybacking strategy, was developed by backtesting results. I don’t expect it to EVER work as well as the results because I designed it to maximum those results.
    5. “Well, Buffett owns it”: Hey, I’m a big fan of following the smart money. Heck, hedge fund replication strategies are built upon the idea that they know more than we do. But don’t ever confuse a single stock pick for an investment strategy. When Buffett buys something, it’s a piece of a larger pie, an additional piece in an investing puzzle known only to him. Beware of cherrypicking guru stock picks.
    6. “You should check out this hot little small cap I just bought. I’m up 100% already”: OK, tough guy. I’d like to see your cost basis on this one. Not that I accuse you of lying but people stretch the truth when talking about their winning ideas. They also don’t happen to mention the ones that they got wrong. Unless they’re audited results like Chris Camillo posted (he turned $20k into $2M — I guess they could be forged), take these claims with a very large bucket of salt.
    7. “You should really subscribe to this penny stock newsletter I get. Great info”: Investors — many smart, educated people — turn their brains off when they subscribe to free or premium newsletters. Many blindly swing at every pitch. The penny stock newsletters are published by stock manipulators. They get paid by large investors to prop up prices, so they can exit their positions. Many are compensated in stock, which incentivizes them to pump ‘em up.
    8. “I’m out! This market is rigged.”: Well, it might be but it still plays by some rules. Insiders have always profited — leveling the playing field with REG FD (requiring public disclosures of important information) didn’t change that. But use the tilt in the field to your advantage. Mimic the insiders and create strategies that follow their trading. I just wrote a free ebook: The Harvard Guide to Insider Trading that describes this technique.
    9. “I don’t know what to do — my broker sucks a$$”: He might. Many do, but there are plenty of trustworthy good financial professionals (yes, even brokers) out there. They put their clients first not matter whether they have taken the fiduciary duty or not. But if you’ve had bad luck, keep looking. Try an online advisor like Covestor (I do freelancing work ) or Personal Capital. or Wealthfront (I’m a freelance writer).  Use Wikinvest portfolio tools (I’m an editorial contributor) or portfolio optimizer, Jemstep. I especially like what Hedgeable is doing. Don’t be complacent – there are new solutions out there that may just work better than the old ones.
    10. “My friends and I are getting into a small real estate deal. We’ll let you in if you behave.”: Sounds like an investment cult to me. If they’re really your friends, I’m not sure you’d have to beg to get into a small deal they’re putting together. Friends get burnt all the time by getting sucked into sucker deals. That doesn’t mean to take a pass on everything that comes your way but it does mean to be very, very, very, very, very picky about who and what you invest in.

    photo by indi.ca

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  • What was Suze Orman smoking when she launched her investment newsletter? (Money)

    Posted on January 24, 2012 at 12:45 pm UTC


    4

  • How to plan an awesome career in finance – with Roy Cohen

    Posted on January 22, 2012 at 1:25 pm UTC

    Roy Cohen is a master career coach. His experience as in-house career coach for Goldman Sachs launched a career in which Cohen has helped thousands of financial professionals.

    He’s the author of the very useful The Wall Street Professional’s Survival Guide

    In this week’s episode of Tradestreaming Radio, you’ll learn about:

    • where the jobs are headed on Wall Street
    • what successful candidates are doing to land their dream jobs
    • common mistakes people make with their financial careers
    • traits shared by top performers

    Awesome opportunity

    Roy is also joining me at the 4 Days to a Better Job: 2012 Finance Career Bootcamp. You’ll get access to Roy and 8 other experts to literally supercharge your job search. Great if you’re trying to break into Wall Street, hedge funds, etc and equally useful if you’re in the market for a better job.

    Loyal listeners of my podcast get an additional 25% off  - if you sign up before January 31. Use the special code PODCAST  to get your discount. Go here to buy your tickets.

    Continue Reading »

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  • The antidote to poor investing returns

    Posted on January 20, 2012 at 12:25 pm UTC

    One of the holy grails of financial research is to be able to identify those traits that make for better investors.

    Why?

    Because if we can isolate those skills top investors have, we can strengthen our own investment activity accordingly.

    A recent study looked at the connection between IQ and stock market participation.

    The real results aren’t what everyone is focused on…

    Continue Reading »

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  • Who are the top marketers in online finance?

    Posted on January 20, 2012 at 9:37 am UTC

    The real story behind growth of online finance companies is that growing true Internet investment firms has moved from an exercise in mass-market brand building to true Internet marketing — including building sales funnels, conversion, and monetization.

    So, who do you think are some of the most talented marketers in finance? I’ve put a few down in the list below.

    Feel free to vote . Who else belongs on this list?

    2.27k views 8 items
    Zack Miller

    Who are the top marketers in online finance?

    Who do you think belongs on this list? Who's doing the best job with marketing in online finance: messaging, branding, and bringing new prospects/clients to their firms?

    Source: http://www.tradestreaming.com/2012/01/20/who-are-the-top-marketers-in-online-finance/

      Follow List
      Embed List
     
    1. Mark Bufalini (LearnVest)

      Mark is the director of user acquisition at LearnVest.

    2. David Frankel (EDGAR Online)

      David Frankel is the CMO at EDGAR Online. Previous, FirstRain, Jaywalk, FactSet

    3. Greg Isenberg (Wall Street Survivor)

      Greg is steeped in the ethos of social media and startup culture. Greg, a digital jack of all trades, has spent the last decade building consumer-web startups that have been featured on Mashable, The Huffington Post, Business Insider, AOL and more.

    4. Hilary Fetter (DailyWorth)

      Strategic marketer with online and offline experience, from start ups to big 'ole household names. The entrepreneurial, in-the-trenches start-up environment is what energizes her most, with runners up including smart ideas, crisp messaging, tight ROI, creative genius, good cheese, cute beagles, and deep powder days.

    5. Sam Yount (Personal Capital)

      VP of Marketing for Personal Capital

    6. Stephanie Sammons (Wired Advisor)

      From time to time I write about personal wealth and investing. I was a financial advisor for 15+ years after all, so it's a part of who I am.

    7. Ramit Sethi (I Will Teach You To Be Rich)

      Are you tired of useless, obvious "financial advice"? Looking for proven systems to make more money? Tell me where to send your free Insider's Kit, and you'll see for yourself why the biggest media outlets on the planet ask me for advice.

    8. Jennifer Doyle (Motif Investing)
      Business and Marketing Strategy Direct Marketing Branding Product Marketing Public Company; 10,001+ employees; SCHW; Financial Services industry Led team of 24 marketing professionals in implementation of all online and offline retail client campaigns to drive acquisition, engagement and profitability.

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About Tradestreaming

Tradestreaming is a community of investors learning directly from experts. I’m Zack Miller, investor, entrepreneur, and founder of Tradestreaming.com and I literally wrote the book on how to invest in the age of Facebook and Twitter. Tradestreaming is the resource I’ve created to help me become a better investor.  I believe it will help you … Continue Reading