Hedge Fund Crowding: Do Activists Create Crowded Names?
When activist managers make a move, how many follow? We'll explore this question along with the ramifications for investors in this article.
“We invest generally in very good companies that have lost their way. And with better management, enormous value can be created,” stated Bill Ackman of Pershing Square, a well-known activist investor. This is one of the main justifications for activist investing. Activist investors utilize their share holder power to push for change in the company. Activists formally accomplish this with a 13D filing with the Securities and Exchange Commission (SEC), which discloses an activist position when a manager owns at least 5% of Shares Outstanding (S.O.). These filings often make headlines—as they did earlier this year when Third Point invested in Whole Foods, pushing for a buyer. A few months later, Amazon announced its acquisition. Once the 13D is filed, many allocators ask how this affects their managers and their underlying positions. One way to evaluate that is to understand the impact activists have on the crowdedness of that security.
Crowded securities across the hedge fund industry can have great outperformance or large drawdowns; it’s a double-edged sword. The Novus Crowdedness index tracks the twenty most crowded names in the Novus Hedge Fund Universe (HFU). Since 2010, this index has outperformed the S&P 500 (BM1) and the MSCI World NR (BM2), but has also suffered drawdowns—like it did in early 2016. These crowded names are a mix of popularity (number of Hedge Funds filing the security) and liquidity (measured through Average Daily Volume). Novus applies these metrics to each security and ranks them to create a crowdedness score from 0.0 to 1.0 with 1.0 as the most crowded name in the universe. Currently, the median of the HFU is .77. An activist investment can affect both popularity and liquidity of a name, and therefore its crowdedness score.
Figure 1: Cumulative returns of the Novus Crowdedness Index compared to the S&P 500(BM1) and the MSCI World NR(BM2).
Figure 2: Historical Drawdowns of the Novus Crowdedness Index compared to the S&P 500 (BM1) and the MSCI World NR (BM2).
How exactly does an activist investment affect the crowdedness of a security? Leveraging the Novus platform, let’s analyze some activist trades and then aggregate this data across a sample set of managers to discover if there is an impact across investment managers.
We compared the crowdedness score of an activist security one month prior to and after the 13D filing. As an example, let’s consider Sachem Head’s 13D in CDK Global (NASDAQ: CDK), filed October 20, 2014.
Figure 3: CDK Global Crowdedness Score as of December 31st 2014
CDK Global spun out from Automatic Data Processing in September, and Sachem Head filed a 13D in October. In September Sachem Head owned 1.50% of Shares Outstanding (S.O.). In total, eight owners in the HFU filed the position and represented 2.06% S.O. The October 13D’s effect on the broader hedge fund universe wasn’t captured until Q4 (December 31st) filings. The crowdedness went from .4339 in Q3 to .8983 (89.83% displayed above). That is >100% increase. While the 13D isn’t necessarily the only reason for the increase (because CDK was a spinout), it often does attract other managers to pile into a name. After the filing, Sachem Head owned 7.87% S.O. and the HFU owned 39.1% S.O. across 56 owners. Although the price didn’t immediately pop, three quarters later it had risen to $54—a 76.00% return—and contributed 17.27% for Sachem Head (based on simulated public holdings).
Figure 4: Cumulative contribution of CDK Global to the Novus HFU
Figure 5: Cumulative contribution of CDK Global to Sachem Head’s public filings portfolio.
Initiating an activist position captures other managers’ attention and can potentially move them off the sidelines to invest. Managers piling in over the course of a quarter made CDK Global a crowded name.
Figure 6: % of Shares Outstanding owned by Sachem Head one quarter prior to their 13D filing.
Figure 7: % of Shares Outstanding owned by the HFU in the quarter end after Sachem Head’s 13D filing.
Let’s examine another example. Pershing Square filed a 13D on Valeant (NYSE: VRX) on March 17, 2015. The filings at the end of the quarter on March 31st showed that crowdedness decreased. Valeant, already a very crowded name, went from .9755 to .9643. Fast forward a quarter and the name went to 1.00, the most crowded name in the HFU.
Figure 8: Valeant reaches a crowdedness score of 1.00.
After this the stock plummeted, and the crowdedness decreased to .79 as people exited; but not before managers suffered negative performance. The entire HFU suffered (-.24%) by the end of 2015, and Pershing Square lost (11.70%) (based on simulated public holdings). Crowded names are painful to exit because of the liquidity constraint, which indicates how large the exit doors are. If managers own a lot of the liquidity of the security, then the doors are small, and inevitably someone gets trapped. In this case the 13D did act as a leading indicator of potential crowdedness.
Figure 9: Valeant stock price drop in 2015 and cumulative contribution to the Novus HFU.
Figure 10: Valeant stock price drop in 2015 and cumulative contribution to Pershing Square.
Activist Impact Across the Universe
We took eight activist managers’ 13D filings since January 2010—99 total filings overall—and examined the crowdedness score across this eight-manager universe one and two quarters after their 13D filings. These managers include Starboard Value, Sachem Head, Third Point, Trian, Blue Harbour, Pershing Square, Corvex, and Elliott. Across the universe, when an activist initiates a position, the given security’s crowdedness will increase an average of 4%. To provide a baseline, the average crowdedness of the HFU since 2010 is .73, while the average crowdedness of a security prior to an activist investment was .8 (meaning activists tend to invest in more crowded names). After activists invest, the average crowdedness of those securities increases to .82.
Figure 11: Average crowdedness scores after a 13D in absolute score and percentage terms.
Activist Impact on a Security
Activists take different stylistic approaches toward their investments. Some managers make a large media splash and hold prolonged fights for a board seat, while others discreetly issue a regulatory filing. Each approach impacts crowdedness differently, attracting or dissuading other manager investments in various ways. Examining the positions’ changes in crowdedness prior to and after the filing for each activist manager illuminates this impact. Some managers increase crowdedness on average (one by 49%), and some see an average decrease in the first quarter after the filing (e.g. Manager 3 had a -1% decrease after one quarter). This implies that some managers attract more attention with their filings than others.
Figure 12: Average crowdedness change in activist positions across managers in percentage terms
Figure 13: Average crowdedness change in activist positions across managers in absolute score terms. (Crowdedness score is from 0.0-1.0) An increase of .239 would mean .6 becomes .839
Activist Impact on a Security Compared to the Market Average
Though we measured the absolute impact of a manager’s activist position on a security, we can remove the average crowdedness of the HFU to see the relative impact. By removing the HFU’s average crowdedness from a security’s crowdedness, we discover whether its crowdedness is above average (positive) or below average (negative). If we do this prior to and after the 13D, then we can gauge a manager’s impact on crowdedness compared to the market. All the managers except one—Manager 2—invested in names that were more crowded than the HFU. Seven managers increased relative crowdedness (compared to the HFU’s) in the subsequent quarter, but Manager 3’s positions slightly decreased after the filing.
Figure 14: Average relative crowdedness prior to and after a 13D filing. Relative Crowdedness: Security A crowdedness = .8 and HFU average crowdedness = .75, so a relative crowdedness of .05. Positive is above average and negative is below average.
In this universe of eight managers, we found that activists did increase the crowdedness of their positions, but each manager had a different impact. Analyzing this impact on a manager-by-manager basis allows allocators to evaluate how their managers add value, whether that manager is an activist or not. Activists draw attention to their names and benefit from herd movement, buying the stock and pushing up the price. Other managers follow the herd because of the draw of a renowned activist play. This increased crowdedness acts as a potential risk. If this herd of followers collectively exits and the activist remains, the activist could be hurt. Managers invested in an activist name could also be hurt if the activist’s plan doesn’t come to fruition and everyone exits at once.
An investor should understand how it is positioned when an activist position is initiated. Overall, how activists impact a security’s crowdedness reveals a manager’s potential skillset or identifies a potential risk that an investor should discuss with their managers.
Novus clients can dive even deeper into this data and leverage the findings to evaluate themselves and their managers.