Nearly six years ago, back in 2013, we presented what we then viewed (and still view) as the best trading strategy of the New Abnormal period, when we said that buying the most hated/shorted names while shorting the names that have the highest hedge fund and institutional ownership is the surest way to generate alpha, to wit:
... in a world in which nothing has changed from a year ago, and where fundamentals still don't matter, what is one to do to generate an outside market return? Simple: more of the same and punish those who still believe in an efficient, capital-allocating marketplace and keep bidding up the most shorted names.
Fast forward to today, when Bank of America confirms that, with just one exception, the historically unvolatile 2017, this strategy has continued to be consistently profitable, as "over the last several years, buying the most underweight stocks by large cap active funds and selling the most overweight stocks by large cap active funds has consistently generated alpha." As BofA adds, the 10 most neglected stocks have outperformed the 10 most crowded stocks by an annualized spread of 8.4% on average during the first 15 days of each quarter since 2012. This is shown in the chart below which reveals that buying the 10 most underweight stocks and selling the 10 most overweight stocks by active funds has generated alpha every year in the past five except 2017.
And despite the market's torrid gains in January and February , this strategy continued to generate profits even in 2019, because after another year of near-record active outflows from active funds(~$370bn), this trend persisted in the first quarter, generating alpha of over 7% according to BofA as the vicious short squeeze of January and February resulted in an outperformance of the most shorted stocks relative to the biggest longs that was the greatest since 2016.
So with institutional ownership seemingly a liability for one more year, we decided to take a look at which sectors are most exposed to hedge fund ownership.
Conveniently, overnight BofA equity and quant strategist Savita Subramanian put together her latest analysis looking at "what your neighbors are doing", i.e., where active fund managers are most concentrated. She found that managers’ exposure to cyclical sectors relative to defensive sectors fell for two straight months...
... reflecting concerns around slowing global growth, rising volatility and geopolitical uncertainties. Among the defensive sectors, Health Care positioning inched higher this month (1.16x), amid another record relative weight (1.56x) in the Health Care Providers & Services industry since 2008. Meanwhile, funds’ underweight in Staples (0.65x) may also be starting to bottom out — after managers reduced their exposure for nearly five straight years — as the relative weight in the sector rebounded slightly from last month’s record low level.
Meanwhile, continuing a trend observed in 2018, tech continues to lose its charm among fund managers, even if the last two months have seen a ramp up in FAANG holdings. As BofA notes, less than a year ago, prior to the Communication Services sector breakout, Tech was the most crowded sector among large cap active managers. The sector now ranks fourth among managers’ overweights, and its relative weight today is at a three-year low of 1.06x. A big driver of this decline has been the Software industry, where managers’ relative weight fell to its lowest level since May 2016 (1.33x). And at a relative weight of 0.63x, Communications Equipment (~80% CSCO) reached its record low level of positioning in BofA data history going back to 2008.
At the same time, Consumer Discretionary grew more overweight by fund managers, where its relative weight of 1.15x is now at a four-month high. Managers increased their relative exposure to Internet & Direct Marketing Retail (80%+ AMZN) to 1.47x, up from its record low of 1.30x in Oct 2018, though still well below its peak overweight of 2.09x in July 2016. Managers’ relative exposure to Automobiles also jumped to 0.78x (vs. 0.46x a quarter ago), its highest level since June 2016.
What about at the individual stock level?
To answer this question, BofA screened for stocks with the most (Table 3) and the least (Table 4) short interest (as a % of float), where the most (~85%) short interest in stocks is from hedge funds. What the analysis found is that the most hated, or shorted, stocks are the following:
- Microchip Technology
- H&R Block
- Snap-On Incorporated
Meanwhile, the least shorted names are, not surprisingly, the blue chips:
- Johnson & Johnson
- Berkshire Hathaway
- JPMorgan Chase
- Wells Fargo
- Twenty-First Century Fox
- News Corp
- Boston Scientific
The full list is below:
To complete the hedge fund exposure picture, BofA also performed a screen of 1) stocks which are most overweight by hedge funds based on their net relative weight in the stocks vs. its weight in the S&P 500 and 2) a screen of stocks which have the largest net short positioning by hedge funds relative to the stocks’ weight in the S&P 500.
According to BofA, these are the 10 stocks where hedge funds have the most net relative exposure:
- Twenty-First Century Fox Class A
- Capri Holdings
- Twenty-First Century Fox Class B
- Advance Auto Parts
- United Continental
While the 10 most net short names relative to net exposure are the following 10 companies:
- Microchip Technology
- Hormel Foods
- H&R Block
- Advanced Micro Devices
- Iron Mountain
- Snap-On Incorporated
The take home: with the Fed once again actively micromanaging the market and flipping financial and economic logic on its head, the best trade continues to be the one that has worked almost every single year (with one exception) since 2009: buy the most shorted names, and hedge this pair trade by shorting the most popular/overweight stocks, a simple trade yet the one which remains the biggest source of alpha this decade.