When Warren Buffett buys a stock it is widely reported by major financial news outlets and investors often follow him into the stock, resulting in an immediate pop. The same is often true when a well-known hedge fund buys a stock.
Because of this, trading with hedge funds might seem like a great idea.
In theory, buying the stocks that some of the financial industry’s best minds are buying is a lucrative strategy. There’s really just one problem: infrequent access to a list of a hedge fund holdings.
But this one problem is a big one.
Within 45 days of the end of each quarter, hedge funds are required to file a form called form 13F with the SEC disclosing certain items such as current holdings. By comparing these filings over time one can piece together what a hedge fund manager bought and sold in a quarter.
It is not uncommon for a stock to get a big pop after a hedge fund manager’s 13F discloses that it is a major holding of the fund. This is clearly the result of investors or even other hedge fund managers trading with the hedge fund.
It’s the investment equivalent to cheating off of one of the smart kids in class, with one major difference – you only get to see the smart kid’s answers four times per year. What if he or she realized they were wrong and changed their answer? You’d never know until it was too late.
Such is the case for trading with hedge funds. It might seem like a great idea in concept but if the hedge fund realizes something is about to happen it can sell the stock before the event to protect itself. You, however, have no way of knowing it has done this until the hedge fund files its next 13F.
Here is an example of when trading with hedge funds goes bad.
John Paulson, a hedge fund manager made famous for betting against the subprime housing market leading up to the financial crisis, runs a hedge fund called Paulson & Co.
In August, Paulson & Co. filed form 13F for the quarter that ended June 30. As of that filing Paulson owned 9 million shares of Genworth Financial (NYSE: GNW), a financial company offering investment services and insurance.
On June 30 Genworth Financial closed at around $17.40 per share, valuing Paulson’s position at $156.6 million. Today that same position would be worth only $85.5 million, a decline of roughly 45%. If that sounds to you like a major loss for the hedge fund you’d be right except for one thing – Paulson & Co. sold its entire stake in Genworth Financial last quarter. The 13F that it filed last week shows that it no longer owns the stock.
If you had bought Genworth Financial because Paulson owned it and didn’t learn that it had sold it until last week you would’ve been burned to the tune of a 45% loss.
After reporting a third-quarter loss and revealing that its insurance business was in trouble, Genworth Financial’s stock fell considerably on Nov. 6.
The decline of almost 38% came just days before Paulson & Co. disclosed that it had exited its position. So piggyback investors would have had no warning that Paulson had sold.
Clearly someone at Paulson & Co. understood something that others didn’t and the entire position was sold for a profit at least a month before the market realized what was happening.
The fact that a hedge fund owns a stock shouldn’t be the reason you own a stock.
It never hurts to see what these funds are buying and selling to help guide your investment research. But trading with hedge funds is a dangerous proposition. They have highly-trained teams watching their investments at all times, ready to sell at a moment’s notice.
Buy stocks because you have good reasons to own, not because someone else owns them.
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