Guide to Hedge Fund Investing

Types of Funds

If you do a google search about the different kinds of funds out there you'd typically find that funds are often categorized according to their legal definitions. They'll talk about differences between hedge funds, mutual funds, close-end funds, etc. At HedgeFollow, we use the term "Hedge Fund" loosely to describe any investment company that buys and sells stocks. We are less concerned whether the investment company meets the legal definition of a "hedge fund" and more concerned with whether it is worth studying the investments of this company.

In fact, Berkshire Hathaway is technically a holding company, not a hedge fund. However, because Warren Buffett is one of the most successful investors in history, the investments made by Berkshire are tracked by thousands of investors, Wall Street outlets, and even other hedge fund managers. Then again, some of the investment companies that do meet the legal definition of a hedge fund can be terrible candidates to follow, the reason being they employ high-frequency quantitative trading strategies that are impossible to follow from simply looking at their regulatory filings.

HedgeFollow tracks ALL institutional investors that submit filings to the SEC, regardless of whether they are a hedge fund, holding company, etc.
However, for analysis purposes, we partition funds into two broad groups:

1- "Hedge Funds"

This group of course includes famous hedge funds such as those managed by Michael Burry and Bill Ackman. However, it also includes all hedge funds, private equity, venture capital, and other private funds that file 13F to the SEC. Also included are famous institutional investors such as Warren Buffett that may not technically be a hedge fund.

These are the funds that we believe may have interesting stock picks in their portfolios. Many of these funds have a longer-term investment strategy that focuses on value, growth, or a blend of both. Some funds focus their investments in a particular sector, for instance healthcare, and hence an investor looking to add some healthcare stocks to his portfolio may be interested in following these funds. Other funds are more diversified, and offer great insight into how they allocate their money to the various sectors of the market.

2- Other Institutional Investors

This group includes all other institutional investors that file 13F to the SEC. This includes many large banks, pension funds, etc.

Examples in this group are JPMorgan Chase, Morgan Stanley, Ubs Group Ag, etc.

You might notice that some of these funds are very large and can contain thousands of stocks in their portfolios. Nonetheless, many investors like to follow them, and try to discern whether they internally rate stocks outperform/underperform based on how they rebalance their portfolios every quarter.

Tracking Hedge Funds

To make the best use of HedgeFollow as an investing resource, it is important to understand how we track hedge funds. By law, hedge funds are required to periodically file documents disclosing their ownership of stocks, options, and some other securities. There are two main types of filings you should know: Quarterly filings and non-quarterly filings.

Quarterly 13F Filings

Hedge funds that manage over $100 million are required to quarterly submit a list of all their stock holdings, including options and some other securities. This document is known as the 13F, and it must be submitted within 45 days of the end of the quarter. For example, funds must detail what stocks they owned on December 31st of 2022, and they have until February 14 of 2023 to do this. These quarterly 13F filings are used by most of the heatmaps and graphs you see on HedgeFollow that summarize quarterly hedge fund activity.

13F Reporting Dates

13F filings require funds to detail their ownership AS OF the end of the quarter. For this reason, you will notice that many records on HedgeFollow have the same reporting date (last day of a quarter, for eg. 2022-09-30).

Non-Quarterly 13g/13d Filings

When a fund buys a large amount of the stock of a company (at least over 5% of the company's shares), they are required to publicly disclose their purchase in 13g or 13d filings. In many cases they are required to do this promptly (they are not allowed to wait until the end of the quarter). Often the deadline for this type of disclosure is 10 days from the date of their purchase, but the deadline sometimes depends on the nature of the fund and whether it intends to influence the management of the company. Thus it is possible to keep track of the latest activity of hedge funds by following 13g and 13d filings. They can happen anytime, anyday, except for public holidays.

When funds buy a huge chunk of a company they typically have two possible objectives:

Passive Investing (13g filing)

Here the fund believes the company is a good investment. The fund is satisfied with how the management is running the company and they made a big investment because they believe the value of the stock will appreciate over time. They must file a Schedule 13g in this case.

Activist Investing (13d filing)

Sometimes the fund believes the company is undervalued, or that it has potential to grow, but needs a little push. If the fund bought the stock with the intention of actively influencing the management (by for example, pushing for board seats and influencing the company's decision making), then the fund is required to disclose this intention. This is done by filing a schedule 13d (rather than the 13g filed when passively investing).

This is where hedge funds differ from the typical average investor. If you are reading this, chances are you fall into the passive investor category. You buy the stock and hope the company management is competent and pray that the stock price rises.

Activist investors are different. Many hedge funds won't sit on a huge investment and just wait to see how things will turn out. They would perform actions that they hope will increase the stock price. For instance, Greenlight Capital bought a large stake in GM a few years ago. David Einhorn, the fund manager, believed it was undervalued (as did many frustrated stockholders at the time). He pushed for corporate action that would split the stock into a dividend-paying stock and a growth stock in hopes of unlocking shareholder value. Eventually the stockholders sided with GM against Einhorn, but the drama between the two brought GM into the spotlight. In fact, the stockholders rejection of Einhorn's proposal was interpreted by many people as a sign of their confidence in the company's management. The stock has risen substantially since that time.

Non-Quarterly SEC Form 4 Insider Filings

In addition to 13G/13D filings, there is another non-quarterly form that is submitted to the SEC by some institutions and individuals. When company insiders (such as CEO, CFO, Directors, etc) purchase or sell company stock, they are required to report these transactions to the SEC. This filing is called the Form 4, and usually must be filed promptly within 2 business days of the transaction.

In addition to company insiders, any institutional investor (such as hedge funds) that acts as a company insider (eg. director) OR that owns 10% or more of a stock must also file a Form 4. Hence we can also use this form to track hedge funds in addition to company insiders.

Using HedgeFollow to track latest Activity

You can see the latest activity of hedge funds using the Hedge Fund Tracker, which tracks ALL the SEC filings we discussed above.

Weaknesses of tracking Hedge Funds

This mini-course would not be complete without seriously discussing the weaknesses of following hedge funds. The following are the major challenges we found when building investment strategies using hedge fund portfolios.

Weaknesses of 13F Filings

The most obvious weakness of quarterly filings is the delay. The majority of hedge funds file their 13F documents right before the deadline. This means a delay of 45 days is typical. The question to ask is whether it is useful to know what stocks a hedge fund owned 45 days ago. The answer depends on the nature of the fund's investment strategy (long term vs short term).

Counter Argument: The weakness may itself be the strength. Why do so many funds wait till the last day before filing their 13F forms? If the information was really worthless after a month, why not file 15 days earlier (especially since they have to file 13F amendments promptly if they made any errors). Furthermore, many hedge funds use long-term investment strategies, it is unlikely that their portfolios will look so different after 45 days. Finally, note that many hedge funds take days to build up their positions in a stock (buying too much of a stock at once may influence its price, they have to be gentle!). Building and unloading investment positions is a process that takes days for larger funds.

Weaknesses of 13g/13d Filings

Luckily many 13g/13d filings don't suffer from the same delay as their 13F counterparts. However, this also means funds know that investors are watching their big moves. A fund can get away from 13g/13d filings by purchasing slightly less than 5% of a company's stock. Furthermore, there are certain conditions that sometimes allow a fund to file significantly later than 10 days.

Counter Argument: Many 13g/13d filings are still very useful due to the short delay. As mentioned earlier, many funds need days to unload (sell) a position in a stock. It's unlikely that the stock appreciated so much in 10 days that they decided to sell off their position.

Weaknesses Common to all Filings

There are some issues that affect all filings. We discuss the main ones here.

1- Only 13F Securities are Filed

Funds do not have to report ALL the securities/stocks they own. They only have to report ownership of stocks that are designated as a "13F Security". Many foreign stocks and bonds are not designated as 13F securities. This means that tracking hedge funds is somewhat limited to the US markets. Some hedge funds that focus their investments in developing markets in Asia/Europe, and these are harder to track. Thus for many funds what we see is an incomplete picture of their portfolios. The more a fund invests overseas, the more incomplete the picture.

Counter Argument: Many hedge funds focus their investments in US markets, so 13F securities cover most of their portfolio. Furthermore, many funds invest in foreign markets through ETF's and investment products that are 13F securities. Note that more than 7,000 US stocks are actually designated as 13F securities. This includes virtually all the US public companies you've ever heard off. Furthermore, hundreds of large foreign companies (Ali Baba, Toyota, etc) are actually listed on American stock exchanges and designated as 13F securities.

2- Long-Only Positions

Funds are only required to report long positions. That is, they are only required to report securities that they have bought. They do not report short positions. This means that it's possible a fund purchased a stock as a hedge against a short bet that was made on another stock. We don't see the short bet, we only see the long position. This might lead us to believe the fund is investing in the stock, when in reality it is simply using it as a hedge.

Counter Argument: Many hedge funds employ a long-only investment strategy. That is, they do not get involved in short selling stocks. These funds are very interesting to watch, because we know for a fact that they are betting on their stocks to increase in value. Furthermore, many hedge funds use put options to hedge (rather than shorting). Funds are required to report put options on their 13F stocks, hence we can see such hedges. At the moment our team is deciding on the best way to incorporate data about options into HedgeFollow. This is a feature that will come in the future.

3- Not all Hedge Funds

Only funds that manage over $100 million have to file their stock holdings. Funds that manage under this amount are exempt.

Counter Argument: Many funds with under $100 million are very small start-ups and may not be interesting to follow anyway. Most famous hedge fund managers work at larger funds (more people have confidence in famous managers and thus those funds will have more investors and more money).

4- Inefficient Allocation of Capital

The market has done really well over the past few years. It's been a clearly bullish market, interests rates have also been low and borrowing money has been cheap. There's an excess of capital among many funds. People, especially those with high net-worth, want to invest their money. When many of these wealthy investors give their money to hedge funds, some funds might find they have too much cash on their hands. They have to invest it somewhere, and since stocks have been one of the few asset classes to give a decent return, many of the funds put the money into the stock markets.

Here's the problem: If they try to buy too much of a small-cap or a mid-cap stock they would push the stock price up to an unfavorable level, making it too overvalued for them or other investors. Thus they would turn to other stocks (in many cases large-cap stocks), not because they are great investments but because they just need to put the money somewhere. Most funds charge a management fee as a percent of capital invested (in addition to a performance commission). Thus, a fund always has an incentive to invest the money rather than return it to the clients. This means making potentially not-so-great investments.

The two paragraphs above explain why hedge funds that are smaller often tend to perform better than large hedge funds. Smaller funds have less money, so they can efficiently allocate their capital to stocks that they believe are winners. As the fund becomes larger and larger, they realize they cannot allocate so much money to the best stocks, they have to invest elsewhere, and the fund's performance begins to drop.

Counter Argument: Honestly there is no easy counter argument here, other than the fact that this is where each investor would make his own investment choices based on his beliefs. Show two investors the portfolios of ten hedge funds and ask them to pick the best 30 stocks. Some of their picks will overlap, but it's very likely that each will have several of their own picks. Each investor has his own style, risk-tolerance, and future outlook.

One metric to look at is the top 20 holdings concentration. This is a percentage that tells you the weight of the fund's top 20 holdings relative to its total portfolio value. You can find it on any fund's page, shown as a small pie chart in the first table. If this is high (the red color in the pie chart is significant), it means a large chunk of the fund's portfolio is concentrated only in the top 20 holdings.

For instance, Warren Buffett's fund currently has a top 20 concentration of over 90%! This is actually unusually high, and is one of the reasons investors pay close attention to his fund. A strong buy/sell action in the top 20 holdings will have a large impact on the portfolio and is likely to be a decision that the fund took after a lot of research.

On the other hand, a fund that has only a tiny portion of its portfolio in its top 20 holdings is likely to be very diversified and own a very large number of stocks. Buy/sell actions in this case will have a very small effect on the overall portfolio. Some funds of this size rebalance their portfolios quarterly based on their views of underweight/overweight stocks.

For those interested in HedgeFollow's methodology, we can only say that our internal investment strategy implements a scoring system to allocate higher scores to stocks based on the likelihood of them being favorable investments. Our data scientists and machine learning experts use AI, machine learning, and statistical methods to model the markets.

Major Issues in Filings Accuracy

Hedge fund's filings are RIDDLED with errors. Wrong stock identifiers, mistakes in numbers, typos in fields, etc. It's actually quite surprising the SEC doesn't fine the funds for many of those errors. Funds often file amendments that correct some of their mistakes, but MANY errors are gone unnoticed. Furthermore, the filings are not adjusted for many of the changes that a stock can undergo. For instance, the filings are not adjusted for stock splits, changes in the stock identifiers, etc. All these things can significantly distort the pictures we get from all this data and lead us to make wrong decisions.

Counter Argument: HedgeFollow.com

Why HedgeFollow is Better

Free FIBI

HedgeFollow was developed FIBI (For Investors By Investors) and is the only free resource on the entire internet that does what it does. It is also ad-free and sponsor-free.

Tracks & Merges Trades from ALL SEC Filings

Some websites track only quarterly filings, therefore missing out on many trades. This is because non-quarterly filings are messier and more difficult to merge with quarterly filings.

HedgeFollow tracks all SEC filings, thus ensuring we don't miss any trades. Furthermore, HedgeFollow merges the latest data from all the different filing types.

When you view a fund's portfolio on HedgeFollow, you are seeing the latest known portfolio of that fund, which reflects the information contained in ALL filings made by that fund up to this point in time.

Massive Data Cleaning & Sanitization

The problem with other websites that attempt to do something like this is that they automate the data retreival to a great extent. They basically just pull the data and dump it as is onto their pages. As mentioned perviously, these filings are riddled with errors. When you just pull and dump dirty data, you import all the errors and issues with that data. These errors are then propagated into any summaries and aggregations that are performed.

At HedgeFollow, we have expert data scientists that perform massive data cleaning and sanitization to ensure our data is as clean and accurate as possible. Human intervention is absolutely necessary when dealing with this kind of dirty data, otherwise our investing conclusions may be based on wrong information.

Of course HedgeFollow is in beta mode and there's still a lot to do. Our data is certainly not free from errors, and we continue to research the best ways to improve our processes and protocols. What we do know however, is that HedgeFollow is the best among what's out there. Otherwise, we would not have created it; we would've just subscribed to one of the websites that claim to do the same thing.

Hedge Funds playing Hide & Seek

Hedge Funds often disclose their holdings in filings made by their subsidiaries or affiliates. There are thousands of registered investment companies, and they are permitted to file on behalf of affiliate funds. In fact, sometimes a company whose name is completely unheard of will make a filing that includes dozens of hedge funds and famous investors. An action of a major hedge fund may be buried somewhere in an obscure unformatted filing made under a different name!
Our systems process hundreds of thousands of filings, running recognition algorithms that detect hedge funds even if they appear in ridiculous places. Furthermore, our algorithms also detect when a fund uses variations of its name (eg. "corp." instead of corporation etc.) which is very commonplace in filings.

A Bright Future

We are continuously developing and expanding the platform to add more features and tools.