Shadow investing - how reliable is it?

07 May, 2021

8 min read

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Shadow Investing - How Reliable is it? - Smart Money
If your tyre went bust on the roadside, and you had all the material to repair your tyre, but no idea about how to do it, what would you do?

It’s likely that you would borrow the skills of a mechanic by taking the car to the nearest garage. Or, if by chance, you saw another driver whose tyre went bust, and who knew how to repair it, then you could simply follow his way of fixing the problem.

When it comes to investing, most retail investors are like the first guy in the above problem - they usually don’t have the expertise to beat the long-term returns of an index, or the market as a whole. Most are not even full time traders, and they are mostly interested in growing their savings to reach a life goal. What do they do? Well, they can either invest their money across a broad spectrum of securities - for example, through an index fund, or borrow the intelligence of other expert investors, for example, through a mutual fund.

What is shadow investing?

Recently, however, another process has come forth in the investments and trading landscape - and that is known as shadow investing. In shadow investing, you simply follow the footsteps of an expert, experienced investor - often known as a marquee investor. These investors are either high net-worth retail investors or institutional investors who are known to dig gold mines with their investments. If you and I were to follow the trades of such an investor, what could possibly go wrong - except for repeating the success story of the investor that you choose to follow? Well, a lot could.

Why shadow investing can turn disastrous

What needs to be understood in terms of shadow investing, is that you, as a retail investor, will always copy the footsteps of a marquee investor - which is not the same as making the exact same moves. If you were copying the exact moves of an investor, that would be called copy-trading, not shadow investing. Just google the term copy trading and you’ll realize what the difference is! The size of your footsteps could vary, and so would the timing. Basically, shadow investing is possible in the first place because of disclosure laws that institutions like SEBI enforce in the markets.

Due to these disclosure laws, you will probably come to learn when a major investor makes an entry into the stocks of a small, medium or an established company. If not through market news, you will find this information in the quarterly or annual reports of a company. However, what you won’t learn is the stakes of your marquee investor in a particular company, or their time of entry. This is where one of the biggest pitfalls of shadow investing comes into sight. 

The pitfalls of shadow investing

First, when you are following a marquee investor, you are unlikely to know as to precisely when the investor made their entry into a particular stock. As a result, you point of entry might be significantly different from theirs. And secondly, an exit from an institutional/high net worth investor might be capable of moving the markets on their own. If they made their exit without taking much profits, you are set to lose on such a trade.

Second, you will likely be unaware of the size of your marquee investor’s stake in a particular company. The problem with this is that your investment in the same company might represent a very different portion of your portfolio than of the marquee investors’. What might have been a high-risk decision representing a small part in their portfolio might turn out to be a much bigger chunk of your portfolio. And more importantly, your risk appetite will be different from the investor you follow by default. In case things go wrong, the losses incurred by both the parties might mean something very different to each of them.

And lastly, shadow investing is marked by an information gap and a simultaneous information lag. Marquee investors often come up with creative strategies that speak to their individual portfolio and risk appetite. Taken in isolation, a single trade or investment made by a marquee investor might just be a pixel in the big picture. This is what can be called as the information gap. Moreover, the time la can subject your entry and exit trades to a very different market and industry landscape than in which the marquee investor made the same decisions. This is a consequence of the information lag - both these problems suggest that the retail investors take a different route than merely making an informed guess at the markets - which is what many analysts have called this phenomenon at its best.

An alternative approach to shadow investing

While shadow investing might not be the answer to beating the market returns, what retail investors can do, is to extrapolate and abstract from the trends of marquee and institutional investors - and seek strategies that tend to replicate similar moves. Another idea for low expertise, low risk appetite investors is to stick with index and mutual funds for a larger portion of their portfolio - following which, shadow investing should be used only to establish one’s own comfort with opportunity discovery and trend extrapolation in the context of solid fundamental and technical analysis.

You might come across many retail investors claiming how they beat the market through shadow investing. In such scenarios, always make sure that you understand the underlying conditions - and a closer look at the numbers. Were the returns reported for a period in which markets were mostly bullish? How did the strategy fare when things went wrong? Answer these questions first before getting caught in a trend that you might regret later on. 

Looking for knowledge on how the market makes money in different ways? Then look no further! Just log on to www.angelbroking.com, and check out our market intelligence and free learning material on the stock market and the economy.

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