BofA Finds The Secret Recipe How To Consistently Beat The Market

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 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 once again 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 the bank 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.

Ok but if we have been writing about this strategy for over half a decade, it should hardly be news to the market which should already have a working, backtested trading model that uses these two inputs as signals, and thus their informational value would be severely curbed. And yet, this strategy's ability to generate alpha continues to surprise because year after year, buying the most neglected stocks and shorting whatever are the top picks du jour of the "smart money" investing crowd continues to be arguably the single best consistent source of alpha in the market.

This is where it gets more interesting.

In an attempt to drill down on how this highly contrarian strategy generates its returns, Bank of America strategists broke down the universe of most disliked stocks by both hedge funds and long long only funds. Next, when analyzing the returns of the "most shorted" basket of stocks by hedge funds, BofA found that those stocks which also have high crowding risk among long-only funds lagged the market significantly (-12.9% vs. +4.7% for the equal-weighted S&P 500). However, when looking at the most shorted by hedge fund basket, that quintile of stocks neglected by long-only funds outperformed the universe by a big margin, tripling the return of the broader market (+16% vs. +4.7%).

Similarly, within the most neglected basket of stocks by long-only funds, hedge funds’ overweights have generated a modest, 3.3% return, underperforming the universe by 1.4% - and "surprisingly" their underweights (“shorts”) by 13%.

Many of the stocks that end up in the prized "most short" (by hedge funds) and "most neglected" (by LOs) bucket, are defensive utilities and REITs, the groups that gained the most in the 12 months since March 2018.

This, to Bank of America suggests that "Long Onlies" and hedge fund positioning data could complement each other as alpha signals. Alternatively, one could have simply done what we said back in 2013, and go long the most shorted stocks (by the entire market, including hedge funds and mutual funds) while shorting the most crowded positions, and generate an average annual alpha of 6.6% (i.e., return on top of the market) in the past 6 years without doing anything labor intensive but merely rebalancing the trade basket every quarter based on publicly available information.

For those eager to recreate BofA's experiment, this is how the bank describes its experimental process:

We divided the S&P 500 universe into quintiles, based on 1) a stock’s relative weight in long-only funds and 2) a stock’s net relative weight in hedge funds as of March 2018. All permutations of quintiles yield 25 separate baskets of stocks, of which we analyzed their average performance over the subsequent 12 months, as shown in Table 3. For example, the top right corner where the Q5 (Short) header intersects with the Q1 (Crowded) header represents performance of stocks with the biggest negative net relative weight by hedge funds and the biggest relative weight by long-only funds.

For those who wish to skip the actual legwork, BofA found that the sectors that the sectors which both mutual and hedge funds like the least today and a year ago include real estate and staples. Meanwhile, contrarians should stay away from consumer discretionary and communication services - these are the groups that both sets of asset managers liked both a year ago and continue to like today.

The bottom line: when we said 6 years ago to buy the most hated names (while shorting the most loved ones) we were right. The question now is whether this apparently still obscure trade will finally stop generating alpha if more investors put it on. On the other hand, since by definition there will always be stocks that are "most crowded" and "most shorted", this may be a strategy that is limited to those who are relatively small and nimble and can avoid moving the entire market. Which incidentally may be the latest reason why this is a market where smaller, contrarian traders will be rewarded even as the "whales" who trade based on idea dinner recommendations are doomed to fade into obscurity.