Nowadays it seems that the popularity of investor letters is on the rise again. Investor letters outline the top holdings of a particular fund as well as highlight a recent investment or a current holding and current views on the market.
Investor letters don’t have to be published by a fund though and no publisher necessarily holds the assets highlighted in the letter’s portfolio. Any one can publish such a letter and a lot do. This is not the issue that I see here. The main problem that I find that some of those letters have is that their advertised performance is not easy to replicate and that they only perform good on paper.
There are a number of reasons that make the advertised performance unachievable. The most obvious one is that some of the assets classes listed in their holdings cannot be bought by the average individual investor. Either because you need to have a certain amount of capital that you need invest in that particular security. For example, some bonds require a minimum invested amount of $100,000, which will not allow for much diversification if your available capital is limited. Another reason might be that your broker does not allow you to invest in those because you are not a professional investor. This is the case with some foreign ETFs. As you can see, holding those securities in a paper portfolio is not a problem and might lead to a good performance (especially when transaction costs are not included), but reality looks different.
Another reason might be that these portfolios include short positions. Sure, on paper anyone and I literally mean anyone can simply short a stock. But reality is far from that. First of all if you want to short a stock you need to borrow it from somehow. What if there aren’t enough people out there that are willing to lend you the stock that you so happen to want to short. This is especially true with some of the not so liquid stocks. And even if you manage to borrow the stock and short it, do you think you can just borrow the stock for free? This is something that all of the letters that I have read miss to include: borrowing fees. Borrowing fees are also not something that will be the same for every stock you borrow. The lender can basically decide what the fee should be and depending on how many people want to borrow the stock the fees might vary. In addition to that, a lender can request their stock back anytime. So if a lender decides that he wants their stock back before the price drops at the levels that you are hoping your performance will be affected by this. On paper though this is never taken into consideration. The letters make it as it is simply borrowing the stock until the price drops by a certain amount without paying any borrowing fees.
All in all there are some good investor letters out there. They are good for getting inspired but don’t expect that you can just replicate their portfolio and get the same performance as advertised. Also make sure to look at their previous holdings. I have heard of letters that remove their bad apples in hindsight with every new letter so that their performance appears to be positive. In other words make sure to track the letter’s performance since inception. In my eyes it is like doing a backtest without taking liquidity, survival bias, transaction and borrowing costs into consideration.