After Three Years, This Remains The Best Trading Strategy

Back in 2013, Zero Hedge laid out what we thought was a simple strategy to outperform the market: in a post titled "Presenting The Best Trading Strategy Over The Past Year: Why Buying The Most Hated Names Continues To Generate "Alpha" we said that "in a market in which all the risk is being onboarded by the Federal Reserve, there is simply no more idiosyncratic risk, and as a result for those so inclined, and preferably running other people's money, a clear "alpha-generation" strategy in which hedging risk is no longer a concern, was to go long the most hated names." Naturally, instead of "most hated" one could simply call them the most "neglected" by the hedge fund community.

Nearly three years later, it is now common knowledge that activist central bankers no longer tolerate fundamentals if it means risking a market selloff, and as a result what used to be investing based on fundamental analysis, is now an anachronism.

But how has this trade done in the years since?

For the answer we go to a report released today by BofA's Savita Subramanian who finds something stunning to most, if very much expected by us.

As flows from active to passive funds have accelerated, one strategy that has worked unusually well for the last several years is a simple positioning trade of selling the 10 most overweight stocks and buying the 10 most underweight stocks by active managers. This single trade has yielded over 16ppt of alpha year-to-date. And implied derisking/ outflows on Brexit alone have been fierce, with the same strategy generating 5.2ppt of alpha just since last Thursday’s close. Even if Brexit’s impact on funds is limited from here, we believe that crowded stocks will likely continue to underperform neglected stocks: a whopping two-thirds of US large cap AUM still resides in active funds - there is likely a lot more to go in the rotation from active to passive.

In other words, the truly contrarian trade we first recommended in 2013 has, as expected, continued to be the best alpha-generating strategy in a market in which clustering hedge funds end up in the same positions, only to see substantial downside shocks on risk event catalysts.

Here is the proof: the Top 10 most overbought stocks have trailed the S&P for each of the past three years, while the Top 10 "most neglected" stocks outperformed the S&P on average by 11.6%.

An empirical analysis of the performance of the Most O/W and U/W stocks over time, shows a stunning 167% annualized spread over the past 4 years based on the 15-day post quarter return, and 16% when extending the performance intercal to three months later: a result most hedge funds would be delighted with.

Of note: it's not all popular stocks that end up losing money. Just the truly most popular, those with greater than 3x benchmark exposure.

Which are the most overweight sectors now, and how does this compare to 3 months ago:

Finally, the most important question: which are the 10 most overweight and underweight stocks, according to BofA? The answer: below.

As in 2013, our advice to those who want to break away from the hedge fund crowd and ostensibly outperform it, pair trade by going long the 10 most hated names, and shorting the 10 most overweight.