Why buy funds when you can buy their best ideas?

Institutional fund managers should be some of the smartest stock pickers in the market yet they’re often criticised for failing to outperform their benchmarks. With the level of underperformance averaging around 3% per year, it’s understandable why many investors have become disillusioned with expensive managed funds.

In the words of celebrated growth investor Peter Lynch, himself a once hugely successful fund manager at Fidelity:

All the time and effort people devote to picking the right fund, the hot hand, the great manager have, in most cases, led to no advantage.

But if you look beyond some of the high costs that damage fund returns, it’s actually possible to find some of the most highly skilled stock picking around. Even better, if you are looking for standout stock picking ideas, fund manager portfolios are some of the best places to hunt.

How can individual investors copy institutional trades?

In many countries fund managers are forced to disclose their holdings data to financial regulators, while in others such as the UK shareholdings are often on record with registrars. In the US all holdings valued over $250,000 are required to be publicly reported by funds on a delayed quarterly basis using the ‘13-F’ disclosure form. These regulations are supposed to encourage transparency in financial markets and lower the incidence of fraud and manipulation of stocks.

Of course, with greater disclosure comes the increased ability of smaller investors to copy their best trades. And there’s plenty of evidence that copying high conviction fund manager trades can generate impressive levels of outperformance.

The difficulty is often just getting hold of the data. While in the USA the data is often available on free websites, in the UK and internationally it’s much harder to get hold of. Luckily at Stockopedia we’ve come up with a great solution that gives access to global holdings data.

So what are the best stocks in institutional portfolios?

For the canny individual investor, there are five Key Rules to separate the wheat from the chaff amongst institutional holdings:

Rule 1. Zero in on a fund manager’s best ideas

As mentioned, fund managers are actually much better stock pickers than the average numbers suggest. By looking closely at the position sizes in a fund, it’s possible to discover the fund manager’s very highest conviction ideas. There is a catch though.

One might expect the best ideas to be the manager’s top 10 holdings by weight, but this would be naive. Because fund performance is usually assessed against a benchmark (like the FTSE 100), a cautious manager fearing for his career may well weight his portfolio similarly. This ensures that the fund performance won’t diverge so far from the index that investors flee.

So it’s only for the very highest conviction ideas that a fund manager will deviate his portfolio weightings most substantially. Indeed, the stocks that have the very highest deviation away from a benchmark weighting (the tilt) seem to outperform the rest of a fund manager’s picks substantially.

In a ground-breaking 2005 paper that examined this common sense idea, it was found that portfolios comprising the top 25% highest conviction positions held by fund managers outperformed the market by up to 23% excess annually.

The second, third, fourth and fifth best ideas perform gradually worse. Anything outside the top five best ideas is unlikely to be a high conviction trade and may underperform accordingly.

Given the delay in reporting new holdings, one might be concerned that all the upside would be hard to capture. But individuals have plenty of time to join the party. A simple buy-and-hold portfolio of these ideas continues to outperform month by month for up to 12 months after the portfolio is constructed.

Rule 2. Stick to the boldest, freshest, most unique ideas

Research into institutional best ideas has shown it to be an effective strategy on its own, but there are other components to this top picks approach that can squeeze out additional profits:

• Freshness: Filtering further to find just the conviction holdings that are being bought or added to can increase returns by several percent per year. The newer or ‘fresher’ a stock idea the better.

• Boldness: far greater returns can be generated by focusing on the very highest tilts. The very highest conviction 25% of ideas outperform by up to 23% per year. The bolder the position, the better.

• Uniqueness: Amazingly, the performance of institutional top picks 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 three managers at a time’.

• Risky Picks: Dramatic improvements to profits were found by adjusting the rankings of each stock in the list by its share price volatility versus the benchmark. This makes sense when you realise it’s the job of a fund manager to smooth returns. This means that overweight positions in risky stocks are highly significant because fund managers will only buy them if they are convinced they have value potential.

Rule 3. Focus on concentrated funds that make big bets

While everyone knows that investment funds often underperform, there is a hidden seam of active funds that can generate alpha by doing things differently. Among them are fund managers that deliberately make big bets on stocks while running concentrated portfolios.

Many big funds own hundreds of stocks, effectively just tracking an index and having very little chance of beating the market. Those funds that are highly focused (in 30 stocks or less) are high conviction funds having a much better chance of outperforming. In 2006, researchers studying fund industry data found that concentrated managers outperformed their more broadly diversified peers by around 4% annualised^[1].

Case Study: Phoenix Asset Management builds a stake in Barratt

In April 2012, Gary Channon of Phoenix Asset Management presented his ‘best idea’ on stage at the London Value Investor Conference. His company had built an enormous position in Barratt Development that at one point became more than 30% of his fund. This ‘big bet’ conviction idea went on to stun the audience with its performance. Those that followed the trade almost tripled their stake in the following 18 months leading to a huge ovation for Channon the next year.

It turned out that these focused managers excelled because their big bets outperformed the top holdings of more diversified funds. This shows that fund managers who tilt their portfolios in favour of their preferred shares are often better at stock picking and identifying the strengths and weaknesses of companies generally.

Rule 4. Seek ideas shared across multiple funds in one firm

While it seems obvious to investigate individual fund manager ideas, what about the best ideas that get shared across their firms?

In 2009, Canada-based finance academic Lukasz Pomorski^[2] investigated whether the common trades of fund managers working at the same firm could continue to beat other trades and the market as a whole. He found that identifying and purchasing the stocks bought across multiple funds at the same firm achieves an outperformance of almost 6% per year.

The research found that these stocks continue to outperform over the next quarter after identification. The effect gets stronger when three or more allied funds trade, and is strongest when at least four funds trade the same stocks.

Stocks that are enjoying improved levels of liquidity tend to attract institutional interest, which pushes up share prices in a reinforcing loop. So the signal here is that while elephants may not gallop, whales move rather slowly as they feed - if you can piggyback a ride on a fund manager’s best ideas it does appear you can make yourself handsomely better off.

Rule 5. Ride the tide of institutional ownership

The number of institutions in a stock generally doesn’t tell you much. But when more and more institutions start clamouring to own a greater percentage of a company’s free float it can create a feeding frenzy and seriously impact the share price.

Work by US academic John Nofsinger^[3] in the late 1990s found that, on average, the 10% of stocks with the largest increase in institutional ownership outperformed the 10% of stocks with the largest decrease by more than 31% per year.

Not everyone agrees about precisely why institutional fund managers influence share prices, but here are some of the most common reasons:

• They can be short-term momentum traders who buy stocks that have risen in price.

• They are adept at forecasting quarterly stock returns and actually lead the market by buying stocks ahead of price movement.

• They are simply better skilled at interpreting stock information and timing their purchases accordingly.

• Their trading in the market conveys information that others copy.

• In stocks where liquidity may be low or the supply of shares constrained, institutional trading can naturally drive prices higher.

In a detailed 2006 study of all these factors, one of the main conclusions was that fund managers are generally better informed than most other investors. As such, their information becomes priced-in by the market as soon as they trade a stock. Crucially, because information plays such an influential role in fund trading, changes in the actual number of institutions in a stock (regardless of whether they are small or large institutions) seems to be more predictive than changes in the percentage of shares that institutions own.

Is it ethical to copy institutional trades?

A growing array of websites like Stockopedia and ETFs are helping sharp investors to profit as soon as institutional trades are disclosed. Unsurprisingly, fund managers in the US have built a chorus of disapproval.

Some think it unethical for investors to copy expensive institutional research processes without sharing the cost. But individual investors shouldn’t feel guilty. Many fund managers hold large numbers of stocks that have little hope of performing well. These stocks are instead bought for reasons that primarily serve the manager’s own interests rather than those of their investors. Just a few reasons include holding stocks in order to:

• Diversify in order to reduce portfolio volatility and becalm flighty investors.

• Act as a liquidity service for customers that need to redeem their investments.

• Asset gather. The fee based pay structure of the fund management business encourages asset gathering - and those assets have to be invested in something, even if it means they can’t be invested in good ideas.

Summary - How to profit from institutional ownership

Increasing numbers of investors are recognising that the actively managed fund industry generally offers poor value for money as a result of high costs and underwhelming returns. In an industry that’s geared up to making a profit for itself first, and its customers second, these numerous intrinsic failings leave investors with the odds stacked against them.

So why should regular investors be held hostage to the economics of large scale fund management? The answer is that they don’t have to be, but they can still benefit from the experience, expertise and stock picking skill of some of the smartest investors around.

With the best data and tools to hand it’s possible to scrutinise fund portfolios for best ideas, high conviction positions and tell-tale trades that signal a fund manager’s favourite picks. Unusually high tilts in a portfolio, ideas that diverge from other fund managers and heavily weighted positions in small or volatile shares can reveal where the smart money sees alpha.

Not only that but insight can be gained from examining top picks across entire investment management firms, watching fund managers that are prepared to make big bets and recognising when institutions are changing their positions in stocks.

Fund managers have extraordinary insight and are capable of making some hugely well-informed and highly profitable trades… but just not that many of them. By understanding the structural inefficiencies in the industry and recognising where the best ideas and top picks can be found, regular investors have a major opportunity to profit from them.