Most Important Stocks in Hedge Funds: Crowding Index
In the latest part in our series of the Four C Indices, we'll take a look at the most crowded stocks in hedge funds and analyze the risks.
Investors and managers alike should be aware of the most crowded hedge fund stocks. But not for the reason you’re thinking: far from being good shorting candidates, this group of stocks have handily outperformed the markets recently.
And now, the most crowded stocks (as we define them) are widening the gap created by their performance above the markets and are seemingly headed for the stars. Here are the simulated returns of our Crowding Index tracking the most crowded stocks, back-tested using daily pricing and P&L, and adjusted for a 46-day lag associated with Public Ownership Data.
The Crowding Index annualized at 16.49% on average, compared to the S&P500’s 8.2% from May 2004 to today.
Imagine our disappointment with these results when we first ran them; in constructing this index we were looking for a short candidate for our clients using public data to create trading strategies. You do not want to be short crowding! Unless, that is, you can time it perfectly.
The Crowding Index shows a lot more volatility than the market. Historically, the rolling 12-month standard deviation has been hovering above the market volatility line.
And the draw-downs have been much more severe. For instance, during the financial crisis or 2008 the index lost 65% of its value compared to 50% for the S&P500 over same time period. Every drawdown since has been more pronounced with the crowded stocks.
September and October of last year was an interesting time because active managers had run into severe trouble even as the broad markets finished in the black. We ascribed this phenomenon to crowding effect we are describing here as well as some other things.
The most important point to consider is that crowding has been on the rise and has become a more prominent issue. When calculated on an aggregate basis (rolling all hedge funds into one huge market value weighted portfolio) the liquidity of active managers is at an all-time low.
This means that managers and their investors should be mindful of a growing illiquidity risk, one caused by crowd selling. As the industry grows in assets we expect this trend to continue and intensify in the future. It will likely play a more and more critical role in the volatility of active manager returns. Managers would be wise to assign a “crowding premium” to the names in their book that are on the below list. While the names are likely to outperform in good times, they are also likely to move violently in a sell-off. Investors may want to understand the reasoning of their managers when purchasing these securities and gauging their managers’ conviction in these stocks. Empirically, the worst thing you can do with crowded stocks is to sell them into weakness.
Here is the latest list of the most crowded stocks in hedge funds based on number of managers long the security and the percent of average daily volume active managers represent.
Learn how investors and managers are using the Novus Platform to track their own skill sets, risks, and liquidity by visiting www.novus.com.