Following the crowd: wisdom or madness?
In our most recent installment, we analyze the usefulness of operating based on the decisions of others, both in consensus and aversion.
In his book “The Wisdom of Crowds”, James Surowiecki argues that many complex problems are better resolved by a diverse group of individuals than by a single expert. You may have experienced this phenomenon first hand as you chose a crowded restaurant over a deserted one, not knowing anything else about the two places. If everyone eats here, they must know something. Most of us would do the same, weighting the popular confirmation from our peers more than a Zagat rating. At the same time when a place becomes too packed it loses certain appeal, as Yogi Berra wisely put it, “Nobody goes there anymore, its too crowded!”
There is an interesting parallel to this in the money management world. A friend that works at a well know hedge fund told me recently that an equities analyst he knows just pitched a great idea to his PM and was rejected even though the thesis was compelling. The reason? “Everyone else is in that name”. This seems to be happening more and more these days. Currently, there is a real aversion and outright avoidance of crowded situations developing in the investment management world. But if you independently come up with a great investment idea, why should the decisions of others, either positive or negative, influence you in any way? Theoretically there is very good reason. If you’re in a crowded restaurant and a fire breaks out you’re going to get burned or trampled by the stampede for the exits.
We saw a mini version of this in the March ’14 reversion of value and momentum factors – we even wrote about it here; managers sold their names at the same time and most popular names got slammed. But there is more to the story – it is very important how you define “crowded”, and it seems that just the number of people is not enough. Going back to our fire in a restaurant analogy, the exits need to be narrow as well.
When we analyzed the most popular stocks among hedge funds, those with the highest number of holders, we saw that the 20 most highly held stocks did not do that terribly in 2008 and 2011 and also held up OK in March of this year. They under-performed in those periods, to be sure, but not by a very wide margin. However, names where hedge funds were most concentrated (if ranked by percent of shares outstanding owned by hedge funds) were down a worrying 7% on average in March. That’s not good for a month when the S&P was flat, to put it mildly. We wanted to dig a little deeper and construct a truly “crowded” portfolio to see how it would fare. To simulate a combination of a high number of people, plus narrow exits we calculated a 50% weighted rank of number of managers (popularity) in each stock and the percent of 90 day average trading volume (narrow exits) they represent. No big surprise – liquidity matters. The crowded names as defined here, tended to severely under-perform in stressed markets and the March reversion. While you might be tempted to think of this portfolio as a great short candidate, don’t go out and sell these names just yet. A crowded hedge fund portfolio, reconstructed each quarter based of 13F data, still outperforms the market by a wide margin over the last decade, albeit with a bumpier ride.
When is it really wise to follow the hedge fund crowd? When a large number of managers express high conviction in certain stocks. Think of it as places where foodies frequently drop loads of green. We call that our conviction strategy and will talk about it in later posts.