How To Track Crowded Securities and Avoid the Herd
In this post, we'll talk about why understanding your exposure to crowded stocks is important, and how to avoid getting stuck in the herd.
We’ve been alerting clients to the growing risk of crowded trades in hedge funds for years now. It seems especially relevant today given all the media attention on hedge fund managers and investors’ desire for unique and uncorrelated sources of return. We think all investors need to understand crowding as a risk factor, just as they do with market regime or company fundamentals. They must also be able to measure their existing exposure to the most popular securities in hedge funds. This is why we’re unveiling a new feature on the Novus platform to all our clients: The Owners Tab. Starting later this week, all hedge fund managers and investors can view their own exposure to crowded trades in real time.
In this article we will explain exactly how to do that. But first, a bit of background to illustrate why this is important.
Why Crowding is an Important Risk Factor
You wouldn’t expect the performance of stocks to depend on the type of investor that owns them. But that’s exactly what’s happened. Below is the performance of one of our crowding factors, the Novus Concentration Index, compared to the S&P 500 TR. The Concentration Index is based off of more than 15,000 securities held in our Novus Hedge Fund Universe (“HFU”), comprised of regulatory filings across 1,150+ fundamental hedge funds, encompassing over $2 trillion in aggregate assets.
The index tracks 20 stocks where hedge funds represent the highest percent of shares outstanding. In some cases, hedge funds represent close to 60% of the shares outstanding. The index includes crowded stocks such as Sun Edison (SUNE) and Community Health Systems (CYH), both north of 60% hedge fund ownership. As you can see, the alligator jaws have opened wide and have remained open for quite some time. In fact, from June 1st to November 4th the most concentrated stocks are lagging the S&P 500 by 25%.
In the most recent days, the stocks have not rebounded as much as expected, suggesting that hedge fund selling pressure is still being exerted on the stocks. Equally important, the underperformance can linger. Below is the 180-day active premium of the Concentration Index to the S&P 500.
The Concentration Index has now fallen to its worst 180-day rolling active premium to the S&P 500, equaling that seen in 2008. (Active Premium is simply the cumulative return of an invesmtent minus that of the benchmark.)
If that’s still not enough evidence for the need to understand your exposure to crowded stocks, here’s more data to convince you: there’s a clear relationship between crowding and performance beyond the 20 most concentrated names. We recently did a study on the highest conviction trades of the Tiger Cubs and found something interesting. In Q3 of 2015 the top 100 Tiger Cubs stock performance seemed to follow a pattern. The more hedge funds represented as a percent of shares, the worse the performance on average.
First, we didvided the 100 stocks into two groups – those that had hedge funds represent more than 20% of the shares outanding, and those with less than 20%. The first group, Low HF ownership, had 59 stocks, and the second group, High HF ownership, had 41 stocks. Below is the average performance of those stocks for Q3 2015.
Breaking this down futher, we can see a clear relationship when bucketing stocks into hedge fund ownership deciles.
How to Measure Your Exposure to Crowded Trades
As I mentioned before, we feel this is so important that we built a feature into the Novus platform to allow our clients to measure their own exposure to crowded trades. This allows hedge fund managers and investors in hedge funds (those privy to positional transparency) to isolate the portion of their portfolio that might be at risk of crowd selling.
For this example I will use a hypothetical portfolio that’s similar to a real hedge fund, but has been constructed for demonstration purposes. Here’s a sneak peak at what the Owner’s tab looks like:
The Owners feature is under the positions tab for any portfolio you pull up. The first thing we show is two bubble charts side by side. The one on the left will plot your positions by number of HF owners within HFU invested in each (X-axis) vs. percent of the 90 ADV that hedge funds represent. The top right quadrant is your most crowded securities, both long and short. The second chart plots the most recent quarter’s performance (Y-axis) against Crowdedness (X-axis). A crowdedness score is assigned to each security based on the number of funds invested and the percent of ADV they represent.
Adding filters, you can study crowdedness in your portfolio across sector, asset class, analyst or other dimension.
The two charts are linked, and they’re also linked to a table below. Clicking on a bubble or table will highlight that security.
You can now clearly see the number of owners, crowdedness scores, percent of shares held by hedge funds, and the most recent buying and selling activity across the HFU. Clicking on the number of hedge funds in each stock will bring you to a list of the owners.
With a longer-term outlook, we see significant outperformance in the stocks favored by hedge fund managers. Over the years, the most concentrated stocks and the most crowded stocks have outperformed the S&P 500 by a very wide margin. But they’ve done so with a lot more volatility and at times surprised their investors with prolonged drawdowns, such as the one we’re in today. I never recommend our clients completely stay away from these stocks. Hedge fund managers tend to know the idiosyncrasies of each specific situation better than anyone else. Having said that, it’s critical that they calculate the crowdedness in the securities they invest in because when it’s time to sell, others may be selling too.