Why is it so important to track the most-crowded securities? Because 80% of these names have crashed since July, 2015.
Nobody goes there anymore. It’s too crowded.
Every time I meet with a hedge fund manager, I ask them what they think the most crowded stock was on June 30th 2015. About half get it right—Valeant (NYSE:VRX) was a magnet for activist, fundamental, and quanta-mental strategies alike. Our Alpha platform showed two red flags for the giant pharmaceutical that investors and managers alike called ‘the new Berkshire Hathaway’: It was the number one most crowded security in a list of 20,000 names in our Hedge Fund Universe. The second red flag was this: not a single Healthcare-focused fund was invested in the stock with conviction.
My next question to managers is this: What’s the most crowded security today? Most simply scratch their heads.
We’ve been talking to clients about crowdedness as a risk factor for years. Managers should be aware of crowded trades affecting their book since it probably drove their performance more than any other factor since last July. It has happened before: between July-September of last year, in October of 2014, and in Q3 of 2011. With each wave, crowding seems to cause increasing damage to manager portfolios, especially to those managers who are unaware of the risk.
Let’s review some important data.
Even after rebounding from a trough in 2014, aggregate hedge fund liquidity continues a long-term trend of decline.
The chart above measures the aggregate 30-day liquidity of the entire L/S Hedge Fund Universe, tracking over 1,200 active portfolios to date. This assumes that managers represent less than 20% of the 90-day average daily volume for each security they hold. This assumption is built into our Alpha platform to account for the threshold at which a hedge fund would move the price of a security. In that case, hedge funds can only liquidate 23.7% of their long holdings, compared to 45.6% in 2009. Overall, market liquidity has not changed as much as the assets controlled by active mangers—those now represent a swelling portion of trading in the markets. This illiquidity is partially driven by managers crowding into the same trades, and that translates directly into performance.
The problem surfaces when managers de-risk or take down the leverage in their portfolios. It’s at this point the most crowded securities can move drastically against them. A good example of this is one of our ‘4C’ Indices, the Crowdedness Index. It specifically tracks stocks that hedge fund managers crowd into, effectively eclipsing all other investors.
To use an analogy, think of a crowded theatre. If a fire breaks out, the number of people that may be hurt in the stampede or burned by the fire is directly proportional to the number of people in the theatre and how narrow the exits are. To take this analogy a bit further, we’ll unpack our proprietary ‘crowdedness score’ that we assign to each stock. To represent narrow exists, we use a ranking of hedge fund liquidity in each stock. The other component is the amount of people in the theatre, or the number of hedge funds invested in the stock. Below is the performance of the Index.
Currently, the stocks are in their worst Alpha drawdown (measured by 1-year rolling active premium) since we began tracking the Index. While informative, it would have been really helpful for managers to identify the most crowded securities before the nosedive. Let’s turn back the clock a bit.
As we mentioned before, in June 2015 (a quarterly holdings release date), the most crowded stock in hedge funds was Valeant Pharmaceuticals.
The stock was trading around $220, still below its August peak. Back then, our clients were looking at the above table, which showed that the stock was held by 106 hedge funds at 38% of shares outstanding and 7.6 thousand percent of ADV. In the coming weeks, as the price cratered, the volume exploded by 10x, going from 1.8M shares exchanged daily to 18M shares a day based on 90-day rolling averages. Hedge funds were frantically trading VRX into the pits.
And VRX was no exception. In fact, an astounding four out of the five most-crowded securities experienced declines north of 60% since July. Liberty Ventures was the only exception, staying close to flat for the period. Don’t forget, these were four out of 20,000 securities hedge funds invest in, and showed up as the most-crowded BEFORE the dramatic price declines. Going back to the theatre analogy, all five theatres were crowded, but only four caught fire. Stampedes galore ensued.
As you may have guessed, none of these names are among the most crowded today. With massive price declines and increased trading activity, the names quickly dropped from the list of usual suspects—the damage had already been done. Before we take a look at today’s most-crowded stocks, a small word of caution.
It is important to acknowledge that crowding does not cause the fire. In each case, there are idiosyncratic factors like debt, bad management, or deteriorating business models that caused initial concerns. Crowding merely exacerbated the moves and increased the casualties.
If there is another deleveraging event, what can we expect to sell off most sharply due to technical pressure? The paper below contains a list of the most crowded securities as of 12/31 filings, along with the constituents of our other ‘4C’ Indices. Our clients will receive a newly minted list in three weeks’ time at the 3/31 filings release.
The Novus 4C Indices track important hedge fund factors through public equities, including the most popular hedge fund stocks, those with the highest conviction and concentration, and the most crowded.
The data underlying index creation is sourced from an aggregate hedge fund portfolio called Hedge Fund Universe (HFU). HFU is composed of over 1,200 vetted hedge fund manager portfolios. It is a subset of the Novus Public Ownership Database of over 10,000 historical portfolios built from regulatory filings around the globe. All the indices described here have been simulated using daily P&L and adjusted for corporate actions and contain 20 equally-weighted positions rebalanced quarterly. For this paper, we do not account for the lag in 13F reporting, using quarter-ends as the knowledge date. Clients can inquire about the lagged versions and the cost of lag associated with a delay in reporting for each index.
Download our latest report to learn more about the Novus 4Cs.Published on April 26, 2016