It's been quoted that a billion dollars a day leaves managed funds in favor of index funds. In this post, we'll examine the reasons.
A billion dollars a day. That, according to Jack Bogle, is the rate at which money leaves managed funds and pours into index funds. “Wall Street hates it. Mutual fund managers don’t like it either.” Hedge Funds are likely to feel this and see outflows this year for the first time since 2008. The reason? Investors lament transparency, liquidity, complexity, and—most of all—fees. But I think it’s mainly this:
Alpha is a performance measure adjusted for risk. Though hedge funds are meant to generate alpha, it’s been declining for two decades. Even if you change your definition of alpha, this is still bad. Thus some investors are packing their bags and investing in index trackers or liquid alternatives. Hedge funds won’t retain assets unless alpha goes up.
Why is alpha declining? Partially due to the market, partially due to managers.
Making alpha is easier when there’s high dispersion, low correlation, and a lot of volatility in the market. Recently, this hasn’t been the case. Generating alpha is also easier when markets have good breadth—ie, when many stocks share the market’s gains. These days, technology shapes consumer trends, making it possible for companies like Amazon and Uber to gain dominance quickly. In 2015 only twenty-eight stocks out of the S&P 1500 made up half the gains of the whole index, and forty-nine stocks made up half the losses. That’s low breadth for the winners, high for the losers. Here’s what that’s looked like in other years:
Low breadth indicates less opportunity for alpha-yielding trades that can handle large amounts of assets. (Read more about breadth). This coupled with a large increase in hedge fund assets means managers must put more dollars into the same stocks to generate alpha.
Managers also shoulder some blame. We’ve found that overlap—the percentage of a portfolio that’s identical for two managers—has grown. Below we’ve calculated a matrix of overlap values for fifty of the largest (non-quant) hedge fund managers and then took the average over time:
Per the above chart, if you chose two managers at random in 2003, only 3% of their portfolio would be identical. Now that number is closer to 10%.
Investing in the same securities isn’t a problem for performance, per se. It only becomes an issue when the securities are crowded. A security’s crowdedness is determined by the number of invested managers and the percent of trading volume they represent. The most crowded securities underperformed the markets by 23 percentage points since 2015—this is the worst relative performance since we started tracking the data in 2003.
Crowdedness has hit record highs. More managers are invested in the same securities, representing higher portions of ADV than ever before. Crowding is likely the biggest risk factor to drive performance in the years to come, yet few traditional risk models track it.
Most models focus on factors like Fama-French. While interesting, these models don’t fully explain the recent decline in alpha. Taking crowding and liquidity into account helps explain a lot more.
Take the particularly turbulent period of July 2015 – June 2016: We ran an attribution analysis on our HFU consisting of individual holdings across 1,300+ managers’ public regulatory filings representing over $2 trillion of assets.
Below are the largest winners and losers for the period. The numbers shown are the P&L (in bps for the HFU) not explained by market and sector trends.
Without understanding the impact of crowding in Valeant, Sun Edison, Allergan, and others, it’s impossible to discover the source of this negative alpha.
What Can You Do About Crowding?
Some of our clients, like us, are uneasy about crowding and are careful not to invest in a crowded stock without buying protection. To make their decisions easier, we calculate a crowding score for every single security and provide a weighted score for their portfolio. This information explains performance and helps the client avoid (or protect from) the most crowded situations.
What are your thoughts on crowding? How has it impacted your portfolio or your investment decisions? Let us know in the comments below. Your answers may be included in our future research.