So do you want to hear about my brilliant idea then?

Baruch was amused by the very earnest discussions he read on Abnormal Returns this weekend about hedge fund dudes sharing ideas. The WSJ had a long treatment on this which also quotes Baruch’s favourite quantademic Andrew Lo, who suggests that hedge fund managers sharing ideas may be creating systemic risk in the form of crowded trades and dangerous correlations.

On the same topic, The Rational Walk (again hat tip AR) has a detailed discussion of the possible motivations for investors sharing ideas. Quoting someone called Whitey Tilson, it posits a few viz:

1) It helps clarify our thinking to put our investment thesis in writing, especially on complex and controversial positions . . . .

2) When it is widely known that we have a position in a particular stock, we often hear from other investors who share valuable information or analyses.

3) Invariably, some people have the polar opposite view of a particular stock and, in sharing it with us, they can help us identify things we might have missed in our analysis. . .

4) When we share our ideas, it creates reciprocity and others share their best ideas with us.

How admirable, you might think. How open minded, open handed and collegiate. Bravo, that man.

Bullshit, thought Baruch.

First off, reading an article about how interesting it is that many investors can own the same security at the same time has the equivalent impact as reading an article tha says sometimes many women are interested in buying and wearing the same clothes at the same time. It is merely another revelation of the bleeding obvious, like the Economist last week which said that stocks which have gone up a lot sometimes go up more.

As for the crowded trades argument, well, crowding in illiquid, systemically important securities using leverage can be dangerous (think subprime CDOs), but I don’t think the Fed should lose sleep if 20 big hedge funds are all long VISA. When that tanked I don’t think anyone other than Visa and Mastercard noticed. It certainly didn’t rock my world.

Let’s not be naive. When it comes to the reasons for sharing ideas, there’s really only one, and OK, maybe a second, lesser but linked, reason why investors share their ideas with each other. The first and only real reason is what we call “reverse broking”, the sole purpose of which  is to make our stocks go up. The lesser reason is that most hedge fund dudes love to show off to their peers. There’s nothing more satisfying than going to one of those dinners, clarting on about your favourite stock and seeing it pop 3% the next day on no news and knowing it was a whole bunch of supposedly intelligent investors copying you because, you think, they think you’re just great.

That’s basically it; the ancilliary benefits to the investment process mentioned by Mr Tilson may be real, but they aren’t even the icing on the cake — they’re maybe the Hundreds and Thousands.

Frankly, these 2 are the only reasons Baruch ever shares his wisdom on particular positions with his peers, be they brokers or fellow strugglers. And you can be as sure as sure can be that when he does so he has bought his full position.* That’s why Baruch smiled at this, from The Rational Walk again:

. . . when Mr. Tilson published his analysis of BP in June, he took the risk that the response may have pushed up BP’s share price which could have prevented him from building up his position as the shares continued to drop in the subsequent weeks.

Right. For him to NOT have a full position at the time he published his analysis would make me, were I an investor in his fund, very angry. How irresponsible, I would think. I’m not paying him 2 and 20 to strew his pearls of wisdom amongst the Great Unwashed for free!

No, Baruch loves his colleagues and competitors, but as he has written in the past, investing at a professional level is a solitary pursuit. You don’t show your work to others unless you have a good reason to. And when people DO share their ideas with you, you’ve got to be pretty uncharitable in your thinking about that as well, because their motivations may not be pure. When Whitney Tilson publishes his ideas as to why NFLX is a great short — after he has lost just a ton of money on it —  can you be sure he’s not just trying to engineer a quick drop in the shares to exit his position with a small shred of honour? Let me hasten to add, I don’t think Whitney Tilson is a bad actor in this way, but trusting the altruism of participants in financial markets is not a well-accepted path to riches.

* this is one of the many reasons that Baruch doesn’t us this blog to pump his stocks. He has too much respect for you, his dear reader, to do that. Note also that if you see anything on this blog which could be construed as positive or negative commentary on a particular stock, it is in no way investment advice. Also you should assume Baruch is long or short to the gills.

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6 thoughts on “So do you want to hear about my brilliant idea then?”

  1. I’m wondering if you feel the same way about AAPL, which is a top 10 holding of at least 75 hedge funds (many, if not most, of which use leverage)? Given it’s 20% weighting in one popular index, the Nasdaq-100, odds are that problems here will have more far-reaching consequences than a sell-off in VISA.

    1. Well I’m not so worried. Or rather, if in the near term anything really bad happens to AAPL, then it will more probably be the economy packing up and going home rather than anything AAPL specific, and then our holdings in AAPL will be the least of our problems. AAPL is highly liquid, and only some of the owners of AAPL are highly leveraged — the 75 HFs we are talking about will in any case likely have leverage of only about 2x, and that should be in terms of gross, not directional, ie net leverage, so if AAPL tanks I am pretty sure some of their shorts will be making them money too. For reference, I understand the bond funds in the subprime crisis were 10-20x leveraged, and were therefore 2000% net long — in illiquid CDOs. Doh!!

      Net net, I don’t think it will be good if AAPL blows up, and it would be much much more impactful than VISA’s little issues. But apart from a few nasty days in the NDX (OK maybe a nasty year in the NDX) and SPY I equally don’t think we need worry too much.

  2. AAPL is selling at a market multiple of estimated 2011 earnings (which are undoubtedly too low). If AAPL were a small-cap stock with the same growth rate and the same PE, it would be viewed as extremely undervalued. I added to my AAPL position this morning. The only thing that really concerns me is that all of the analysts also remain bullish. Yes, a lot of hedge funds hold AAPL, but if the stock dips below 320 almost all of those funds will be buying, not selling. It seems pretty clear that AAPL and Jobs timed the announcement the way they did because they expect the earnings announcement to be dazzling enough to make investors stop worrying about the impact of Jobs stepping down. It is not AAPL that is dangerously overvalued but stocks like FFIV, CRM, and NFLX.

  3. Thanks again, Baruch, for distilling it for me (I actually mean that). For a lead piece, that WSJ article was absurd – as if an editor said, “Get me this.”

    In reason #3, Tilson may have something. What if they really did screw up their analysis, and someone like, I don’t know, David Einhorn, said “You have it all wrong.” Their limited partners might like that.

    Isn’t Tilson that woman who’s always showing off her body on CNBC?

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