2021 and The Novus 4Cs: Anomaly or Cop Out?
The last year forces us to reflect on our namesake data indices. Has our contrarian joined the masses?
In a twist on Theodore Roosevelt’s famous speech, “The Man in the Arena,” investors should understand “the credit belongs to the contrarian who is actually in the arena.” The best investors know successful trades are both contrarian and right. Contrarian investing can be lonely, but when the masses catch up to a meticulously researched thesis that is proven correct, there will be outsized performance. On the contrary (no pun intended), trading patterns for crowded or consensus trades may behave differently than expected as a thesis is proven correct and can grossly underperform when a thesis is called into question. $GME exposed the danger of joining the crowd in an overwhelmingly crowded short trade.
The Novus 4C Data Indices (Quick Refresher)
We created four indices to track the most popular stocks among hedge funds:
- Conviction: stocks with the highest number of hedge fund managers invested with conviction—i.e. an outsized position in their portfolio
- Concentration: stocks with the highest percentage of shares held by hedge funds
- Consensus: stocks with the highest number of hedge funds invested
- Crowdedness: stocks with a combination of high number of hedge fund owners and low liquidity
Over the last 18 years, the best of the 4Cs has been the basket of Conviction names with a 16.7% annual return which outpaces the S&P 500 by almost 500 bps. These names represent the best ideas across our tracked universe of hedge funds, and the outperformance demonstrates the collective skill of managers for research and sizing. At its best, research intensive investing uncovers contrarian gems that outperform the market, and the best managers know how to upsize these opportunities accordingly.
Not surprisingly, the laggard of the 4Cs is the basket of Consensus stocks which has underperformed the S&P 500 by 6 bps annually. These names represent lazy, consensus-driven decision-making as managers hear a good thesis and throw a small position onto the books to commence diligence—technically popular while hardly an idea that shows conviction. Many look to Consensus names as fodder for short ideas.
Crowded and Concentrated stocks are the most dangerous, with outsized standard deviations of 21% and 25% respectively versus 14% for the S&P 500. More telling, in 2008, both Crowded and Concentrated names plummeted 54% versus a 39% decline for Conviction names. In 2015, with the market up just 2%, Crowded names declined 19% and Concentrated names declined 31%.
2021 & Turned Tables
During 2021, the Novus Conviction index is 370 bps below its long-term average while the Consensus Index is 1000 bps above its long-term average. As a result, the Conviction Index—comprised of the best ideas across the Hedge Fund Universe—has underperformed the “lazy, consensus-driven decisions” that comprise the Consensus Index by more than 900 bps year to date.
In a what-have-you-done-for-me-lately world, the “critics point out how the strong man has stumbled.” Is this a myopic, year-to-date lens? Or is something fundamentally shifting?
History suggests, we should not count out the person in the arena whose face is marred by dust and sweat and blood. The Conviction Index is less than a quarter of a standard deviation below normal this year, whilst the Consensus Index is performing 0.9 standard deviations above normal. Of the two, Conviction performance in effect fits nicely within its historical bell curve. What is unusual is the decided outperformance of the Consensus Index relative to both the Conviction Index and relative to its own history.
Peeling back the onion, it could be that the contrarian in the arena is cowering with the masses—but who can blame them given the recent Consensus performance? Looking at positions, the Conviction and Consensus Indexes appear to have converged. Today 11 names appear on both the Conviction Index and Consensus Index, whereas ten years ago only six names overlapped. Compared to the S&P 500, eight of the Conviction names are one of the 20 largest stocks on the S&P 500—AAPL, MSFT, GOOG, AMZN, FB, BRK.B, V, and MA—compared to just four names ten years ago. The Consensus names have a 1.6x higher overlap with the top-heavy S&P 500 at 13 names—AAPL, MSFT, GOOG, AMZN, FB, NVDA, BRK.B, JPM, V, JNJ, MA, ADBE, and PFE. Going back ten years, 15 names on the Consensus Index were top 20 S&P names. Does this suggest the best hedge fund idea (Conviction Index) is to go long the top of the S&P 500? Lately, this has been a great trade. In fact, seven of the eight names that are both in the Conviction Index and top 20 positions in the S&P 500 were on the Conviction Index five years ago; those seven names are up 288% over the last five years.
Is Consensus the New Best Idea?
For a complete answer, I'd encourage you to explore our post Which Factor is Truly a Best Idea? The summary is as follows—Although Conviction and Consensus share a stronger overlap at present, the basis of these two indices make it impossible for the two to be unrelated. Consensus captures the most popular stocks overall, and Conviction measures those that are most popular to invest in with conviction. The differences are historically finesse—Conviction’s superiority is found in its sensitivity to equity market dispersion, comparatively less relative value and momentum beta, and an exposure that is less explained by traditional factors. To us, the evidence still suggests Conviction remains the more accurate and consistent measure of hedge fund best ideas. But you are encouraged to roll up your sleeves and explore yourself on our Novus 4Cs dashboard.
Turning our attention back to the individuals behind the index, let us ask: Are the best and brightest ready to transition their best ideas?
At one third normal volume, the median Conviction name would take 32 days for hedge funds to exit. What happens when the masses decide to fade big tech?
Trading on a median PE of 37x earnings, the Conviction Index seems more Consensus than the Consensus Index at 31x earnings. Perhaps the best hedge fund managers will resume their contrarian ways in their highest conviction ideas now that the Fed has signaled it will stop pumping juice into the market. To generate positive absolute returns in a rising rate environment, hedge funds will need to successfully find idiosyncratic winners.
The Takeaway for allocators
Ask your managers about their conviction in the top of the S&P 500. Can a hedge fund manager really be both contrarian and right by betting on a highly consensus trade?
The Takeaway for managers
If you are going to fail, “at least fail while daring greatly so that your place shall never be with those cold and timid [indexing] souls who neither know victory nor defeat.”