market folly

In Jim Chanos' recent interview with CNBC, he made comments about the 13F filings that hedge funds are required to file with the SEC each quarter and said investors should be wary of using them.  This post will present his comments and then present a counter-argument in a post we're calling: The Pros and Cons of Tracking Hedge Funds Via 13F Filings.


The Pitfalls of 13F Filings 

13F filings disclose hedge fund long positions in US equity markets, American Depositary Receipts (ADRs), both put and call options, as well as convertible notes.  They do not disclose short sales, cash positions, or any other asset class.  Of these quarterly filings, Chanos said:

"If you don't know the other side of the book, it can be very misleading."

This is obviously true and is why 13F's have to be taken with a grain of salt.  Shorting is an essential part of a hedge fund.  After all, that's what puts the 'hedge' in hedge fund.

His statement is even more pertinent to funds that put on pairs trades or are trying to hedge out certain exposures.

Chanos gave a perfect example where he is short Hewlett Packard (HPQ) as his core position.  But he has hedged out enterprise exposure to the name by being long Microsoft (MSFT) and Oracle (ORCL).  By hedging as such, Chanos is effectively shorting a segment of HPQ's business: laptops, printers, and anything "ink" related.

And that's the problem: the SEC filings will only disclose his longs in MSFT and ORCL.  Without him revealing that he is short HPQ, you would assume he is simply long those two stocks, which couldn't be further from the truth.  It's an incomplete picture.

Chanos' rationale could also apply to risk arbitrage focused funds.  One might look at the 13F's of these managers merely to see which merger deals they are playing.  That said, you have no clue how they've hedged out the position (unless they disclosed puts).


Why 13F's Are Worth Looking At

In his interview, Chanos went on to say:

"And I caution anyone looking at our 13F's, or any hedge fund's 13F's by the way... you don't see the other side of the book, and it's very scary to invest, just saying."

He's 100% right on one point:  They aren't required to publicly disclose their short positions so half of the portfolio equation is indeed missing.

HOWEVER, you also have to keep in mind that Chanos' hedge fund Kynikos Associates is a short-biased fund and they're net short.  Therefore, Chanos' 13F is different from that of other hedge funds because Kynikos' core positions (shorts) are hidden from disclosure, while their hedges (longs) are publicly disclosed.

Typical long/short equity funds are often the exact opposite, i.e. they are net long, so they reveal their core positions (longs) while their hedges (shorts) are hidden from public view.

So in Kynikos' case, it absolutely makes sense to disregard their 13F filing.  But for other hedge funds, it's worthwhile to look at 13F filings and here's why:

While some managers are more skilled on the short side and see solid performance attribution from that portion of their book, a big chunk of a fund's performance can often be attributed to their long positions.

In 2010, Alphaclone posted an article that compared actual hedge fund performance numbers to those of a portfolio cloning only the publicly disclosed long holdings via 13F filings.  The results were very interesting in that the 13F clone portfolio performance numbers were largely in line with those of the actual hedge fund performance numbers.  Their article comparing 2012 performance thus far shows the same results.

This is because net long funds have most of their capital invested in their long ideas and for the bulk of these managers, this is where their performance comes from.  This is why looking at 13F's for their longs makes sense.  That said, you can't just track any manager's 13F.  Tracking 13F's is only useful if you know which funds to track.

And even though Jim Chanos told viewers to be cautious when viewing 13F's, he admitted that his firm looks at them too: "If (a 13F) overlaps with one of our longs or shorts, sure my trade desk will flag it to me or head of research."


Keys To Tracking Hedge Funds Via 13F's

After tracking SEC filings for almost a decade, here are 7 keys we've learned to safely tracking hedge funds via 13F filings:

1.  Only track long-only or long/short equity fund managers: And add an asterisk to this point as well: only track managers that normally run net long.

Tracking global macro funds (Bridgewater, Tudor) or credit funds (Fortress, Cerberus) is misguided because the vast majority of their positions are in asset classes that they don't have to disclose (futures, commodities, bonds, currencies, etc).  And while quant funds (RenTec, AQR) often disclose stocks, following them is a folly because you have absolutely no idea why their algorithms bought in the first place. 


2.  Track funds that primarily invest in domestic markets:  13F's only disclose activity on domestic stock exchanges and do not reveal international holdings (except for ADR's).  Therefore, you want to keep an eye on funds that will have the vast majority of their equity exposure in the US.

If you follow international managers, just know that only a small slice of their portfolio would be disclosed (if they hold any US longs at all).  You'll have to track international managers via foreign regulatory disclosures as well (something Market Folly strives to do via this link for UK activity and this link for Hong Kong activity).

A manager that invests primarily abroad could disclose a position in a US-traded stock and if you're only looking at their 13F you'd think they've made a big wager when in reality that holding could be one of their smallest because you can't see their international plays.  You have to place domestic positions within the context of their entire (global) portfolio.


3. Focus on long-term investors with lower turnover: 13F's are filed on a delayed basis and it is basically a snapshot of a fund's portfolio from 45 days ago.  A manager can easily sell out of a position by the time a filing becomes public.

This is exactly why following long-term oriented funds is key: to reduce the effect of the delayed disclosures.  Long-term investors are more likely to hold on to positions for an extended period of time.

Many long/short equity hedge funds actively trade around positions and so manager selection for 13F tracking is crucial.

Readers constantly ask us to cover activity from well known funds Steve Cohen's SAC Capital due to popularity, so we oblige.  But in reality, SAC is a horrible fund to track via SEC filings due to the fact that they actively trade in and out of stocks (not to mention there's a ton of portfolio managers each doing their own thing).

This is why value investors are often good bets to track: they buy and hold (or at least typically hold longer than one quarter!)  Even so, through backtesting 13F's, Alphaclone found that for most L/S funds, the "average holding periods are much longer than most people perceive them to be."  So the effect of the delay in disclosures is smaller than you think.  They've found the average holding period to be around 1 year.

Managers that run concentrated portfolios are also usually good bets because they have lower turnover and every position adjustment they make is that much more important to their portfolio.  The same can be said for activist investors (for example ValueAct Capital) that take a stake in a company and try to help implement positive change over longer periods of time.


4. Look at a fund's larger positions (top 30 holdings or so):  The rationale here is to focus on their core positions that represent a larger percentage of their portfolio because most money managers allocate the most capital to their best ideas.  It's also worthwhile to place an emphasis on stocks that show up as 'new positions' in their disclosures as these are their most recent ideas.

Some investment managers hold hundreds of positions (Soros Fund) and as you go down the list of their holdings, each stake becomes a much smaller percentage of their portfolio.  It's much easier for funds to exit small positions and more often than not, these are lower conviction bets. 

Additionally, sometimes these smaller positions aren't what they seem.  In the past, we posted up a quote from T2 Partners' Whitney Tilson on why he had a small long position disclosed in his 13F in a stock he'd said publicly he was actually short:

"A lot of people make this mistake when reading 13-Fs: managers often own puts (which are also disclosed in the 13-F) or are short a stock (which isn’t disclosed) and then own a small offsetting long position to make it easy to trade around it."

Sometimes on 13F's, very small stock holdings are actually trading positions that hedge funds use to manage net exposure to a name they're actually net short.  So, focus on the upper echelon of their long portfolio. 


5. Take it with a grain of salt: The delayed nature of SEC filings means that you're looking at hedge fund activity in the rear view mirror, or in a tracking sense: following their footsteps.  While the effect of this delay isn't as bad as you think as illustrated earlier, there are many variables at play here.  Managers can move in and out of positions for any number of reasons.  So when viewing 13F's, remember that a) it's not their whole portfolio and b) it's a past snapshot.


6. Use it as a starting point to do more research:  Do your own due diligence.  It's one thing to know that ABC manager bought XYZ stock.  It's quite another to know the investment thesis behind *why* they bought the stock.

At the Value Investing Congress recently, Greenlight Capital's David Einhorn mocked investors that don't do the work and just try to blindly follow him.

However, 13F's are a great place to find ideas.  Fairholme Capital's Bruce Berkowitz has said in the past, "We use a lot of grapevine ideas... Why not look at what other great investors have found?"  The key here is to use it as a starting place and then to do your due diligence.  

This is exactly what MarketFolly does with our premium newsletter: Hedge Fund Wisdom. 


7. Monitor all SEC filings, not just 13F's:  MarketFolly keeps you afloat of the latest hedge fund portfolio activity via 13G filings, 13D filings, as well as various Form 3 and Form 4's filed with the SEC.  These disclosures are filed on a more timely basis and provide a more current look at what managers are buying or selling.  They help bridge the time gap between quarterly 13F filings and hedge funds are required to disclose when they've purchased 5% or more of a company. 

Additionally, if you can track managers via their quarterly letters, annual meetings, and investment conference appearances, this gives you the most up-to-date information regarding their portfolio (at least what they choose to reveal).  MarketFolly tracks all of these via the links above.


Conclusion

Jim Chanos is 100% correct that you have to use caution when examining 13F's because they do not show the short side of a hedge fund's portfolio.  However, tracking the 13F's of equity focused hedge funds that run net long can be beneficial for idea generation provided you know which funds to track and that you take everything with a grain of salt.

Check out how we analyze hedge fund 13F filings in our premium newsletter: click here for a free past issue.