The Recent Equities Sell-Off: Our Thoughts And Evidence To Boot by Stan Altshuller, Novus
Story time
People love stories. Since childhood we are drawn to clear causal relationships where a set of actions lead to a plausible outcome. Birds ate the breadcrumbs so the children were lost in the woods; she was bruised by a pea under her mattress so she must be a princess. Humans are inclined to automatically link cause and effect, it’s pleasing to understand the “why”. Investors are no different (we are only human after all) and these days everyone looks for logical explanations for occurrences that surprise us. The last six weeks have been a good example. Investors in global equities voiced their opinions as the markets slid over 7% accelerating the slide in the recent weeks. Some pundits have even called it the end of the bull cycle. Many are keen to find culprits pointing at falling crude prices and the reaction of energy sector stocks. Others paint hedge funds as the aggravators of this downside volatility. Since we collect and analyze mountains of data on hedge funds we decided to test this last claim. We found some compelling evidence that hedge funds did play a role in the recent sell-off and may have been disproportionally hurt, similar to the dynamic we saw in March and April. Just like you, we love plot lines and stories, so get your blanky out, here goes…
Brief review
The world runs on oil and its fitting we start there as energy effects all aspects of the economy. In the face of the US shale boom and increasing output unleashed from hydraulic fracturing, new crude is flooding the market. Yet world-wide demand remains stagnant pressuring prices as they slid over 20% since June. One way to slow the decline would be for other oil producing countries to limit supply, but OPEC has not been willing to slow production, further depressing oil. The decline in oil prices in turn put pressure on energy stocks as this chart from WSJ illustrates. As energy and materials stocks suffer, so does the rest of the market. One of the hardest hit sectors is transportation, specifically the airlines. But airlines should profit from falling fuel prices, right? The plot thickens.
How do hedge funds fit in?
Hedge funds are the smart money of investment management, they are usually very sensitive to developing trends and are quick to react when a fundamental shift in the market takes place relative to, say retail investors who are slower to act and more prone to chasing whatever has worked in the past. It would be no surprise then that hedge fund managers have taken advantage of the rally in energy stocks as that sector has returned over 13% for the first half of the year, outperforming the broad index by over 6% from January through the end of June. Indeed, it turns out that hedge funds were overweight energy by far the most of all sectors and have reaped the rewards. Of course, this did not bode well going into September. Take a look at the below table listing the GICS industries and their respective performance for the general market as well as hedge funds[1].
In the last six weeks, energy was one of the worst performing sectors for the S&P 1500 and the worst performing sector in our hedge fund universe, constructed to mimic hedge fund holdings. You’ll notice that hedge fund stocks in Energy have performed worse than their non-hedge-fund-favored counterparts. And our cause and effect-seeking minds suggest that the reason is hedge fund herding. We do have some evidence. Take Cheniere Energy, Inc. (NYSEMKT:LNG), for instance, a high-conviction bet of the hedge fund world with sizable allocations from over 80 managers and 33% of outstanding shares held by hedge funds is down 18% – there’s one source of drag on the hedge fund crowd. The transportation sector is one where the discrepancy is even more striking, hedge fund stocks were down a whopping 8% more than their GICS benchmark! Introducing Avis Budget Group Inc. (NASDAQ:CAR) with 57 hedge funds taking up 45% of the shares outstanding and representing 3,000% of the 90 day average trading volume. The stocks is down 26% since September 1 and the only real news – a repurchase program which should be bullish for the stock price. Why is this happening you ask?
The fact that hedge funds react quickly can be a blessing and a curse. In the long term they will benefit from picking great stocks and timing big trends. But in the short term they become victims of their very own nature and suffer the effects of herd selling. Trying to get out of stocks to lock in previous gains can be bothersome when your hedge fund friends are doing the same thing at the very same time. Selling pressure depresses the price further, exacerbating the need for more managers to get out and nobody wants to be last.
Breaking it down further
To better gauge the effect of this hedge fund selling on the broader market we looked at the returns of hedge fund favored stocks by sub-industry. If managers selling at the same time can move stocks, they can move industries and consequently they can move markets. The below chart shows a clear relationship between the worst performing stocks and their allocations from hedge funds. Those industries with highest HF allocations above the benchmark allocations (most overweight) have performed the worst. Maybe that is why airlines are down in the face of declining energy prices? After all, Delta Air Lines, Inc. (NYSE:DAL), down 18% for the period is held by 117 hedge funds. Or at least was held by that many.
[1] Source – Novus Global Ownership database. Hedge funds were isolated from a list of 10,000 institutions down to 1,000 hedge funds managers. Only public filings were used in the analysis. Only long positions are included. There is a 45 day lag on most disclosed positions, the latest 13F filings are as of 6/30/2014 when this article was written.
