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 three weeks ago, when Bank of America confirmed once again that with just one exception, the historically unvolatile 2017, going long the most shorted names and shorting the most popular ones has continued to be not only the most consistently profitable, alpha-generating strategy, but that in 2019 YTD, the top 10 crowded stocks underperformed the 10 most neglected stocks by 19% YTD, a 5-year record!
Indeed, never has the power of positioning been more active than in 2019, when as BofA recently calculated, the overlap between positioning by mutual funds and hedge funds reached an all time high, and as a result, "positioning has been a big driver of returns in 2019" (we discussed this topic far more extensively back in April in "BofA Finds The Secret Recipe How To Consistently Beat The Market").
Now, with the mandatory several week (or year, depending on how one looks at it), it Goldman's turn to warn that "as recession fears rise, so does the risk from crowding", or said otherwise, ever greater "crowding" by hedge funds in a handful of positions has rapidly emerged as one of the biggest risks to the increasingly illiquid market.
Of course, the fact that most hedge funds are unimaginative copycats of others' best positions is hardly a secret: after all recall that just before it imploded, serial fraud Valeant was a top-10 most popular firm among the hedge fund community, a place it reached thanks almost entirely due to lazy analysts and countless cross-polinating idea dinners.
Which is why Goldman's Ben Snider writes that for more than a decade, hedge funds have steadily increased the concentration of their portfolios while decreasing position turnover, which makes sense in a market in which there is increasingly less differentiation between stocks all of which rely on passive investing (ETF) flows, buybacks and Fed policy.
The result, as Goldman shows, is that the average hedge fund now holds 69% of its long portfolio in its top 10 positions, up from 57% 15 years ago. In 2Q 2019, the average fund turned over 26% of distinct equity positions, a figure that typically registered between 35% and 40% per quarter during the last cycle. Turnover of the largest quartile of positions registered just 15%.
Meanwhile, as groupthink became a dominant phenomenon, in addition to holding fewer, more concentrated positions, hedge funds increased their crowding in common positions, a dynamic that has contributed to the strong recent performance of momentum, a strategy usually associated with 20 year old PhDs who think they are financial geniuses, simply because they do what everyone else is doing, and by definition, accentuate a trend, which works great until it doesn't and everyone is margined out (as some very prominent quant funds can attest in recent months).
As shown below, Goldman's hedge fund crowding index shows a general trend of rising crowding this cycle, with particular spikes during periods of economic stress. Although crowding is currently far less extreme than it was in early 2016, it has risen so far this year. At the same time, our long/short Momentum factor has outperformed sharply, a dynamic also characteristic of markets concerned with economic growth.
So for those who have missed one of our hundreds of articles on the topic of crowding risks, why is any of this notable? Because, as Goldman explains, "the recent increase in hedge fund concentration and leverage make funds particularly vulnerable to a potential market unwind, particularly if accompanied by the decline in liquidity that typically coincides with falling risk appetite."
The last statement is a follow up to an earlier analysis by Goldman, which looked at the way US equity market liquidity has changed over time and how investors can boost returns by accepting liquidity risk. In recent weeks, as fears of economic recession have spiked, so have equity volatility and illiquidity, following the usual pattern.
Goldman's bottom line: Investors concerned about crowding risk should consider protecting their portfolios through the bank's Hedge Fund VIP basket, which amusingly was created precisely to make such crowding easier. Which is why it will come as no surprise that the basket has exhibited a larger beta to the S&P 500 during market declines than rallies and has historically been correlated with changes in fund leverage.
And just to make sure Goldman creates a self-fulfilling prophecy, in which the VIP basked of most popular HF positions ends up being the catalyst that crushes hedge funds, and ultimately sparks a market correction, the bank explicitly states that investors "should particularly consider hedging if the valuations of the most popular hedge fund positions continue to expand. Valuations have historically been a useful signal for Hedge Fund VIP performance (see Exhibit 16). Today, the newly rebalanced VIP basket trades at a 13% forward P/E premium to the S&P 500 (19x vs. 17x). In the past, a 15% or greater premium has often signaled negative forward three-month excess returns for the basket."
Which, of course, is just another way of saying that while there are periods when the most crowded positions outperform the market, over a long enough timeline, such crowding results in frequent, periodic and quite spectacular blow ups.