Copycat investing, as the name implies, refers to the strategy of replicating the investment ideas of famous investors or investment managers. The strategy is also known as coattail investing, since the investor rides on the coattails of those who presumably have much more investment prowess. But is copycat investing a viable investment strategy? While the evidence about its success is somewhat mixed, there are certain techniques you can use to increase your chances of becoming the perfect copycat investor.

Mixed Evidence – Buffett Bootleg versus Miller Mime

The long-term success of legendary investor Warren Buffett has attracted a host of copycats over the years, and that could be because replicating Buffett’s strategy has made people money. According to a 2008 study by Gerald Martin and John Puthenpurackal, a hypothetical portfolio that invested in Berkshire Hathaway’s investments a month after they were publicly disclosed would have outperformed the S&P 500 by an annual average of 10.75% from 1976 to 2006.

But before you rush off to check Buffett’s current holdings, consider the other side of the coin, when a long streak of outperformance ends with a resounding thud. Fund manager Bill Miller joined the pantheon of great investment managers after his Legg Mason Value Trust Fund beat the S&P 500 for 15 years in a row, from 1991 to 2006. Miller’s fund had a bad year in 2007 – losing 7% while the S&P 500 advanced 5%. But 2008 was an outright disaster for the Value Trust, which plummeted 55% compared with a 37% plunge for the S&P 500, as Miller loaded up on flameouts like Bear Stearns and AIG. In the five-year period to March 2012, the Value Trust fund posted an annual return of minus 6.9% even as the S&P 500 gained 2.0%, underperforming the benchmark index by almost 9 percentage points on an annual basis. Investors who had mimicked Miller would have rued their decision if they had continued to do so after 2006.

Copying the Copycats

Copycat investing is more widespread than one would think, although it is often done discreetly and without much fanfare by institutional investors like mutual funds and hedge funds. But the idea of latching onto someone else’s investing ideas really seems to have caught on among retail investors. In fact, Boston-based research firm Aite Group named “copy trading” as one of the top 10 wealth management trends for 2012 in January of that year.

The earliest copycat investors would routinely scour regulatory filings from mutual fund companies to discover which stocks star managers had loaded up on in recent months. Nowadays, websites such as tickerspy.com and gurufocus.com offer an alternative to this arduous process by tracking and displaying holdings of the best investors and investment managers.

The trend of “mirror investing” has copied the copycat strategy and taken it one step further. Services such as Covestor and Ditto Trade enable an investor to link investment accounts to portfolios actively managed by other investors or investment professionals, and automatically mirror every investment move that the latter make. Covestor has over 150 portfolio managers whose investment holdings can be mirrored by investors, and discount brokerage Ditto Trade has thousands of what it calls “lead traders” with an average of three to five followers per trader. The obvious difference between copycat investing and mirror investing is that the former attempts to duplicate trading ideas only of well-known and recognized investment gurus.

Who Should You Copy?

Investors considering a copycat strategy should consider replicating investment ideas from the following sources:

• Successful money managers . All institutional money managers with over $100 million in qualifying assets are required to file quarterly an SEC Form 13F detailing their investment holdings. This is a great source document for copycat trades.
• Buy-and-hold managers . Copycat investors would be much better served getting ideas from long-term managers who believe in buy-and-hold, rather than investment pros who are short-term traders. This is because the time lag between an actual trade and its reporting may be a detriment to effective trade replication. It’s better to go with someone like Buffett, who has often been quoted as saying “Our favorite holding period is forever.”

• Activist investors . Activist investors like Carl Icahn can usually cause a stock to appreciate as soon as the news of their involvement in the company becomes public. Icahn, in fact, often shares his investment plans through Twitter, which makes it easier for copycat investors to act on them rather than waiting for regulatory filings.

What are the Risks?

Like any other strategy, copycat investing has its share of risks, such as the following:

• Success is not guaranteed: No investment strategy is a sure-shot winner. For example, a copycat investor may have to stick with the strategy for many years if he or she is following a value-based manager, since value stocks sometimes take an eternity to turn around. Losing patience and abandoning the strategy prematurely may result in substantial losses in this case.
• Stock may have already moved: A stock may have already moved significantly between the time it was acquired (or disposed of) by a money manager and the time this news is made public. This has an adverse effect on the stock’s risk-reward profile for the copycat investor.
• Too many copycats: Too many investors – retail and institutional – are watching the top hedge funds and money managers. Given the speed of information dissemination and trading nowadays, an investor who is a little late to a copycat trade is at a huge disadvantage, because the stock may have already moved quite a bit in a short time span.
• Differing investment horizon/objectives: Your investment horizon and objectives may differ from that of the money manager. For example, you may have a very short-term horizon, while the manager you are copying may be in for the long haul. Or the money manager may have a risk tolerance level that is much higher than your own.

How Should You Do It?

Here are some suggestions to consider while implementing a copycat investment strategy:

• Follow credible, successful professionals: Stick with the tried-and-tested money managers, since you may occasionally come across a stock that could be a spectacular success. As an example, Carl Icahn sold close to 3 million shares of Netflix (Nasdaq:NFLX ) in October 2013, after the stock had more than tripled that year. Icahn’s average cost of the Netflix stake was $58 when he originally acquired the shares on Oct. 31, 2012. A year later, the shares were sold around $323 for a gain of 457%. Copying a timely investment like that could juice up returns for any investor’s portfolio.
• Exercise patience: Chasing a stock is never a good idea. If a stock has already moved up on news that an investing heavyweight has taken a position in it, the best course of action may be to wait for it to come within your buying range. If it does not, move on to something else.
• Look for accumulation: Large-capitalization stocks that are having hard times may be a great opportunity for patient investors. Look for such stocks where money managers have commenced accumulating significant positions, since this signals their confidence of a turnaround in the near to medium-term.
• Follow investment pros in different sectors: Don’t put all your eggs in one basket by focusing only on investment professionals in one or two sectors. Many top managers and investors in a specific sector have a considerable degree of overlap in their holdings. Diversify your copycat strategy by replicating investment ideas from gurus in different sectors.
• Conduct your own due diligence: Do not assume that copying trades from the best money managers around absolves you of the responsibility to conduct your own due diligence. Ensure that copycat stock you are considering is suitable for your investment objectives and risk tolerance before you acquire it.

The Bottom Line

While copycat investing has its risks, common-sense measures – such as following successful investors, exercising patience, looking for accumulation, diversifying with different sectors and conducting your own due diligence – can help you become a (near) perfect copycat and improve your chances of investment success.

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