In Justifying Hedge Fund Groupthink, Goldman Butchers The Greeks (Again)
It was just under a year ago that we first learned that Greece had been cleverly scheming to fool the EU, EuroStat, and investors, foreign and domestic, about the true nature of its fiscal deficit courtesy of various currency swaps constructed by none other than Goldman Sachs: a process which would end up being the first time the "Greeks" were butchered by Goldman. The whole purpose of Goldman's innovative "revenue scheme" was to allow the Greek government to skirt the 3% fiscal deficit limit imposed by the EU on peripheral countries, in essence making Greece appear far stronger for years than it really was. It is this deceit that laid the seeds for the current Eurozone insolvency which requires a virtually daily bailout. Amusingly, yesterday we also learned that it was the US Federal Reserve which knew about this willfully fraudulent misrepresentation as long ago as March 2005, as disclosed in the most recent Fed minutes: "CHAIRMAN GREENSPAN. Can we borrow from the Greeks? [Laughter] MR. KOS. It’s interesting, since they are at about double the 3 percent limit. So the markets are not punishing anybody for not complying." Of course, nobody is laughing now that the markets are certainly punishing those for not complying with a vengeance. Had the Fed brought attention to this, the outcome for the now doomed Eurozone and the EUR would have been different. Now it's too late. And in this vein, on Friday it was once again Goldman which put the last nail in the coffin of the "Greeks" only this time not so much the insolvent nation, as the much-suffering letters α and β. The reason for this is that also on Friday, the WSJ ran a great article which basically blasted hedge fund groupthink, confirming that the only so-called strategies that work now are those that copycat the whale asset managers (courtesy of much delayed 13F/G filings). David Kostin, fearing that his groupthink-promoting authority is being challenged (not to mention his recent promotion to partner at Goldman), immediately came to the rescue of the hedge fund hotel habituals, in essence saying that beta is really alpha, and only fools don't do what the big boys are doing. In traditional Goldman fashion, ruin follows about 5 years later to all who follow the firm's advice (long after the commissions have been converted to gold stores in various non-extradition countries). This time we are confident the event horizon will be far shorter.
First a quick look at the key WSJ observation:
Hedge funds are crowding into more of the same trades these days, amplifying market swings during crises and unnerving investors. Such trading has stoked market jitters in recent months and helped to diminish the impact of corporate fundamentals on stock-market movements. Droves of small investors have reacted by pulling money from the market, questioning its stability and whether fast-moving traders are distorting prices.
The pack behavior undermines the image of hedge-fund chiefs as savvy money managers who sniff out investment opportunities that others don't see—thereby justifying the hefty fees they charge clients. It also suggests that hedge funds are having a harder time coming up with money-making ideas in rocky markets.
One explanation is that they are focusing increasingly on the same stocks. Last year, for example, stock in Apple Inc. was held by 55 of the nearly 200 large hedge funds tracked by AlphaClone LLC. In 2008, by comparison, the favorite hedge-fund stock, Microsoft Corp., was held by 34 funds.
"The whole hedge-fund industry is a series of crowded trades," says Mr. Lo.
Of course, this all works miracles on the way up, when the pleasant melt up is first created by the big whales, those located the closest to zero cost of debt financing, then the slower and dumber pilot fish, then finally the retail lemmings. And when everyone rushes to the exit you get a May 6 event.
It has gotten so bad that even traditional venues such as Value Investing Club (not to be confused with the irrelevant "Congress") where prominent hedge fund manager pseudonyms and their proxies would talk their positions as soon as established, see little participation commentary any more:
Mr. Loeb, once a proponent of exchanging ideas, has changed his tune. "We will no longer discuss investments made prior to our public" filings, Mr. Loeb wrote in a June 2010 client letter. "We have found that discussing our ideas may result in 'piling on' by other hedge funds who may subsequently sell at inopportune times resulting in greater hedge fund concentration and volatility." Mr. Loeb, whose main fund gained 34% last year, declined to comment.
One area where the groupthink phenomenon is very hot and heavy is in the quant world where pustular 19 year old math PhDs seek safety in numbers to validate that their only trading gimmick, be it regression to the mean or momentum chasing, is viable for another few milliseconds.
SEC examiners in recent months also have questioned "quantitative"
traders, who rely on computer models, about any information they're
passing to each other and how, say people familiar with the matter. The
SEC declined to comment.
Yet it is precisely this focus on the woefully stupid approach of trading on others' coattails that has gotten the green light for a response from the very big boys: in this case Goldman Sachs, and its key voodoo chartist: David Kostin.
We recommend investors use our hedge fund holdings baskets to generate alpha during “risk-on” rallies and as a tool for risk reduction during periods of elevated market uncertainty. Our analysis shows hedge fund holdings generally outperform during equity market rallies and lag during corrections. Time horizon is vital to understanding how hedge fund ownership data should be incorporated into the portfolio management process. On a daily or even weekly basis hedge fund positioning is noisy in terms of explaining relative excess return. However, on a quarterly basis the hit rate of outperformance of hedge fund positions is notable.
So somehow Goldman makes alpha the equivalent of beta. And not just any beta, but very, very levered beta. The kind that requires an account to be in very good standing with Goldman's Prime Broker group so that leverage comparable to that last seen in the summer of 2007 can be applied with impunity. And then when it is unwind time, the dumb money can ride in on indications of interest born from stale 13F filings, and which most often see the original money selling their shares to the last hot potato holders. Just like Greece back in the early 2000s, which closely followed Goldman's advice and ended up being broke, so those who follow Kostin's advice and become the latest entrant in the biggest hedge fund hotel in the world, Apple, will end up either bankrupt, or begging for ECB assistance on a daily basis. In the meantime, Goldman is merely doing its civic duty to make everyone join in a dance which has increasingly fewer stocks in it, in a market that has increasingly less volume participation, and in the process collect what is left of trading commissions. As for the next step: well, Goldman has a very active debtor restructuring group and will be happy to pitch its services too...
Full (ir)relevant commentary from David Kostin:
A front page story in today’s Wall Street Journal (“Hedge Funds’ Behavior Magnifies Swings in Market,” January 14, 2011) highlighted the relative performance of so-called “crowded” hedge fund trades versus the broad market. The premise of the article is that hedge fund ownership magnifies the beta of particular stocks and reduces the importance of company fundamentals in determining share performance.
We long ago concluded that money flow is important to the performance of stocks and that it made sense to follow the proverbial “smart money.” We have analyzed more than 7,000 individual stock and ETF positions of roughly 600-800 hedge funds every 90 days for the past decade. Five years ago we started publishing our quarterly Hedge Fund Trend Monitor to track the hedge fund money flow into and out of individual stocks and hedge fund sector tilts on both a long and net basis.
1. Time horizon is vital to understanding how hedge fund ownership data should be incorporated into the portfolio management process. On a daily or even weekly basis, hedge fund positioning is noisy in terms of explaining relative excess return. However, on a quarterly basis the hit rate of outperformance of hedge fund positions is notable.
For example, our basket of stocks with the “most concentrated” hedge fund ownership (Bloomberg ticker: <GSTHHFHI>) has a 71% hit rate of quarterly outperformance versus the S&P 500 since May 2001 with an average quarterly excess return of 296 bp. Our basket of “stocks that matter most” to hedge funds (<GSTHHVIP>) has outperformed the S&P 500 on a quarterly basis 66% of the time since 2001 by an average of 74 bp. [and here we get the all important footnote from Goldman: "Note: The ability to trade these baskets will depend upon market conditions, including liquidity and borrow constraints at the time of the trade." in other words everyone can get in, but when everyone has to get out, nobody will. Enjoy.]
2. Our analysis shows hedge fund holdings generally outperform during equity market rallies and lag during corrections. We recommend investors use our hedge fund holdings baskets to generate alpha during “risk-on” rallies and as a tool for risk reduction during periods of elevated market uncertainty (see Exhibits 1-3).
For example, our “most concentrated” hedge fund basket has outperformed the S&P 500 by an average of 868 bp (745 on median basis) during the six rallies since the market low in March 2009 and underperformed the S&P 500 by an average of 322 bp (385 bp on median basis) during market corrections.
The reverse is also true! Our basket of “least concentrated” hedge fund positions (Bloomberg ticker: <GSTHHFSL>) lagged the S&P 500 during market rallies by average and median of 69 bp but outperformed the broad market by an average of 99 bp (37 bp on median basis) during corrections.
Our hedge fund VIP list (Bloomberg: <GSTHHVIP>) consists of stocks in which fundamentally-driven hedge funds have a large stake. We define stocks that “matter most” to hedge funds as the positions that appear most frequently among the top ten holdings within hedge fund portfolios. For this analysis, we limit our hedge fund universe to funds with 10 to 200 distinct equity positions in an attempt to isolate fundamentally-driven investors from quantitative funds or funds that mirror private equity investments. Hedge funds own between 1% and 38% of the equity cap of the stocks in the basket with an average of 9%, almost twice the 5% average for the S&P 500.
By construction, our VIP list identifies the 50 stocks whose performance will largely influence the long side of many fundamentally driven hedge funds. The VIP basket lagged the S&P 500 by 822 bp during 2008 (-45% vs. -37%). It reversed in 2009, outperforming S&P 500 by 1,391 bp (40% vs. 27%). In 2010, the basket outperformed S&P 500 by 443 bp (19% vs. 15%).
Our VIP basket has a large-cap bias with a median market capitalization of $49 billion compared with $11 billion for the S&P 500. The VIP basket overweights the Information Technology sector (24%) and underweights Industrials (2%). Turnover for the VIP basket since 2001 averages 34% quarterly (52% annually) with 17 stocks typically entering the basket. The next re-balancing will take place after February 15, 2011.
Current constituents of our hedge fund VIP basket scheduled to report 4Q 2010 results next week include the following. Tuesday: C, AAPL, IBM. Wednesday: WFC and USB. Thursday: GOOG and FCX. Friday: SLB and BAC. Exhibit 52 contains the complete list of constituents for all three baskets.
We define “concentration” as the share of market capitalization owned in aggregate by hedge funds. The stocks in the “most concentrated” basket tend to be mid-caps (at the lower end of the S&P 500 capitalization distribution). Hedge funds own between 17% and 48% of the equity cap of the stocks in the basket with an average of 24% vs. 5% for the S&P 500. Stocks with the “most concentrated” hedge fund ownership outperformed the S&P 500 in 2010 by 84 bp (16% vs. 15%).
In contrast, hedge funds own between 0.2% and 0.6% of the equity cap of the stocks in our “least concentrated” hedge fund basket with an average of 0.5% vs. 5% for the S&P 500. The basket outperformed the S&P 500 in 2010 by 255 bp (18% vs. 15%).
Translation: ignore the voice of reason which argues that if everyone else is on the same side of the trade, then you are the guaranteed sucker on the table, and instead follow the Siren song promising untold riches... until such time as there is an actual downtick in the market (better known as the 100 or so shares that make up 50% of market volume) and where no matter how hard you try to get out, you are stuck. For reference: see the first time Goldman butchered the Greeks...
And some pretty charts: ignore the fact that the least concentrated stocks are solidly outperforming their most widely held cousins...