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Concentration, Consensus

The Factors Behind Hedge Fund Performance: The 4Cs in 2019

Andrea Gentilini Chief Executive Officer

An update on our Novus 4C Indices as of the most recent quarterly filings. The 4Cs track the most significant hedge fund factors today.

As with every quarter, asset managers were required to file updated Form 13Fs in mid-May, reflecting their March 31st holdings across domestic public equities. This led to a flurry of headlines, directed towards famous money managers and their stock picks. At Novus, we take a systematic approach to analyzing aggregate trends across all hedge fund managers who file ownership data, delivering that insight the day after filings are due to our clients. A unique window into hedge fund movements are the Novus 4Cs, informal indices which explain hedge fund behaviors across four unique vectors. Each is designed to explain fund manager positioning through a unique lens, and offers its own historical risk and reward dynamic. Let’s dive into some key takeaways from this quarter’s 4Cs, starting with Figure 1, below.

Figure 1: Top adds and sells from the most recent filings, in addition to top performers and detractors so far in 2019

Conviction

Conviction securities had a strong start to the year, with the Novus Conviction Index returning ~17% through the end of May. The index acts as a good proxy for hedge fund core risk allocation across domestic equities, and reveals some interesting trends.  First, funds continue to gravitate towards event-driven and merger-arbitrage exposure. Notable conviction holdings this year include CELG, FOXA, FDC, RHT, and TMUS.  This may be a function of increased risk aversion towards market-sensitive bets. Over the quarter, hedge funds added exposure to ADBE, while exiting BKNG. Core exposures in FANG remained constant.

Crowdedness

Crowded stocks garner a lot of attention, especially when markets enter periods of volatility. Hedge fund crowded stocks, as measured through our Crowdedness Index, suffered in 2018. These stocks pulled back nearly 20% in the fourth quarter and over 14% for the calendar year, badly underperforming domestic indices.  2019 has been a kinder environment for crowded names, but the bounce back has been weaker than for Conviction stocks, as we have commonly observed. Crowded names were up 14% through April, trailing the market during its upswing. A rough May did not help. Crowded stocks lost nearly 10% in May, underperforming as broader equity markets swooned. These securities tend to have amplified sensitivity to broader market trends, with a historical beta of 1.2x and wider up/down capture ratios. New additions to the Crowdedness Index for the quarter include RRC and AXTA, while the index dropped KHC. Why such strong moves versus the market?  Well, market volatility tends to amplify the stock movement of crowded names, which suffer from selling pressure as active manager de-risk their portfolios. This will be a key indicator to watch in 2019 alongside broader market-level volatility.

Consensus

The most popular names held across hedge funds, Consensus provides a proxy of standard picks across portfolio managers. The index was up over 12% through May, acting as a gauge of the “healthy” hedge fund stockpicking so far this year. The index added NFLX and CELG during the quarter, while exiting WFC and CVS.  As to be expected, exposures tended to be larger in capitalization, including FANG stocks and lower beta mega-caps such as JNJ and JPM.

Concentration

Stocks with the highest concentration of ownership across hedge funds were far more volatile than consensus picks. According to the Novus Risk model, this basket of securities sported a 24% expected volatility at the end of May, compared to just 14% for Consensus securities (more below). This makes sense, as the basket includes more specific, niche exposures (e.g., biotechnology). The index returned 13.4% through May with a wider spread of winners and losers. New entries are almost all on the smaller capitalization spectrum, including WVE, ECOM, and LJPC. The index exited energy and biotechnology exposures such as CLVS, MPO, and LNG.

Cross Comparison Across the 4Cs

Across all indices, we saw small bits of common ownership, with 12 stocks being shared across two of the indices. No securities were held in 3 or more Cs. Figure 2 depicts the percentage of the portfolio that overlaps each other, a measure similar to active share. This particular overlap metric – cross – allows you to see common holdings in relation to a foundational portfolio (the portfolios listed on the y axis). To unpack the graphic, 25% of the single-name exposure in the Novus Crowdedness Index is also held in the Concentration Index (and vice versa). Similarly, 65% of the Conviction Index is held in the Consensus Index.

As you can see, the overlap tends to exist either in both concentration / crowdedness, or in conviction and consensus. This makes sense, as concentration is an input into the calculation of crowdedness, while common conviction and consensus may be indicative of hedge funds’ “best ideas.”

Figure 2: Novus Cross-Overlap calculated across Novus 4 C Indices

Names with common ownership between indices include the following:

Figure 3: Common securities held across pairs of 4C Indices

As mentioned before, we have witnessed different risk profiles for each of the 4Cs. Figure 4 (below) shows two risk metrics: the expected volatility of each index (blue), versus the historical realized volatility (orange) over 15 years of history. As we can see, the biggest difference between realized and expected volatility can be seen across crowded stocks. This is perhaps due to fund managers currently crowding into lower expected risk situations, such as merger/arbitrage, as expected volatility is far below realized volatility.

Figure 4: The difference between current expected volatility and the historical realized volatility of the 4C indices. We highlight the relative difference in the Crowdedness Index.

Ultimately, fund managers and capital allocators should be aware of exposure to each of these factors in their portfolios. They can be significant drivers of both risk and return. They also provide added insight into the behavior of their portfolios beyond traditional style factors. Users of the Novus Platform can analyze each of these indices in depth. Request a free trial today to explore the 4C Indices on the Novus Platform.

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