Hedge Fund Cloning Strategy Shows Massive Outperformance

In his MarketWatch column, Mark Hulbert discusses an investment strategy based on imitating hedge funds, which was developed by Mebane Farber of Cambria Investment Management. Faber argues that “we can duplicate [the best hedge fund’s] investment performance without having to pay a penny in management fees” by reviewing their holdings (which are publically available with a maximum of a 45-day lag) and imitating carefully. Specifically, “the key is to construct a portfolio of the stocks [the best funds] own,” while avoiding their biggest investments. This latter point comes from Faber’s finding that “the typical hedge fund’s largest holding underperforms its other holdings.” Faber tested a strategy based on “an equally weighted portfolio from the top five holdings of each of [his] favorite hedge funds – after removing the fund’s largest holding,” which “should be rebalanced quarterly” as publically available reports are filed by the funds. Back-testing this strategy to 2000, Faber found that it would have beat the S&P 500 by more than 6 percentage points annually through 2015. Picking the best hedge funds is, obviously, crucial. Faber suggests “focusing only on those with consistent records over long periods” and “avoiding those whose good record derives from only one or two huge winners.”