"Throughout all my years of investing I've found that the big money was never made in the buying or the selling. The big money was made in the waiting." - Reminiscences of a Stock Operator by Edwin Lefevre
Almost without fail, when we describe AlphaClone to people, one of the first questions we get is about the rate of turnover amongst funds we track and how that affects clone performance. We thought it would be a good idea to address that very issue in this week's article.
First the basics. We track about 250 funds - they are a mix of hedge funds and institutional funds. The table below summarizes turnover statistics for each group:
Fund Type # of Funds Turnover Q4 2008 Turnover Average* Hedge Funds 148 57.30% 48.90% Institutional Funds 102 26.80% 20.70%
As you can see from the table above, hedge funds tend to turnover twice as much as institutional funds - no surprise there. What is not apparent is that the 48.9% average turnover number for hedge funds in the table above is significantly higher than the historical average for the group, which is about 40%. Hard to predict the future but we expect that turnover for that group will begin to revert to the historical mean as the financial markets stabilize.
In any case, let us get back to how turnover effects clone performance. Turnover figured so prominently in our thinking when we were building AlphaClone that we decided to create a dynamic fund group that selects funds based solely on turnover. The AlphaClone "Low Turnover" fund group selects the 25 funds that have the lowest average turnover over the past four quarters. The group is dynamic so it runs the selection process each quarter (i.e. the funds that make up the group can change each quarter).
Next we looked at how each of our "clone strategies" faired when applied to this specific group. Just to remind you, there are three basic clone strategies:
- Top Holdings: based on the top holdings amongst funds in the group
- Best Ideas: based on the largest new buys amongst the group ("Best Ideas")
- Popularity: based on the stocks that are held by the largest number of funds in the group
You can vary the number of holdings in each strategy and run backtests for each "variant" (e.g., Top 1 Holding, Top 3 Holdings, exc.) but to keep things simple we've selected one variant from each strategy and summarize the relative performance in the table below:
2000-2009 Top 3 Best Ideas Top 3 Holdings Top 3 Popularity S&P 500
Index Ann. Return (%) 3.6 -0.8 -4.8 -4.3 Volatility (%) 20.0 16.2 21.1 16.0 Sharpe (4%) 0.0 -0.3 -0.4 -0.5 Max Drawdown (%) -45.2 -49.9 -60.8 -50.9 Best Year (%) 52.7 35.4 33.6 28.7 Worst Year (%) -34.8 32.9 -36.6 -37.0 Rank* 14 of 22 17 of 22 14 of 25 n/a # of clone holdings Up
to 50 Up to 75 Up to 3 n/a
Based solely on the results above, it seems that a strategy that follows the "flow" tends to perform well on low turnover funds. The Top 3 Best Ideas clone beat its benchmark by nearly eight percentage points annualized since 2000, with comparable volatility and a lower maximum drawdown. However, it is also likely that low turnover by itself is probably not the best or only criteria one should use to select funds to clone. All three highlighted strategies for this fund group were in the middle of the pack when ranked versus other fund groups for the same clone straegy based on annualized performance since 2000. So how can you use the above analysis? Well one way to use it that may prove interesting is to pick out one individual fund from the list of 25 funds that made up the Low Turnover fund group in the most recent quarter and look at the Best 3 Ideas strategy for just that single fund. We did that for Dodge & Cox and its Top 3 Best ideas strategy outperformed the market by 12.3 percentage points annualized since 2000. The bottom line is that in cloning, sometimes "going with the flow" is in fact the "best idea."
