Hedge Fund Crowding Update – Q3 2016

Hedge Fund Crowding

Whereas most analysis of hedge fund crowding focuses on individual stocks, over 85% of hedge funds’ recent long equity variance has been due to their factor (systematic) risk. Residual, idiosyncratic, or stock-specific bets accounted for less than 15%. Thus, factor crowding has dominated hedge fund industry’s absolute and relative returns. This article reviews the most crowded hedge fund long equity bets at 9/30/2016.

Understanding and quantifying this factor crowding is vital for hedge fund investors and allocators: Factor exposures that are shared by the entire hedge fund industry and that can be obtained cheaply with passive funds do not warrant the same compensation as the distinctive insights of gifted managers. Even worse, crowded bets expose investors to damaging stampedes during liquidations.

Identifying Hedge Fund Crowding

This article’s approach follows our earlier studies of hedge fund crowding: We started with a 10-year survivorship-free dataset of SEC filings by over 1,000 hedge funds. We then created a position-weighted portfolio (HF Aggregate) comprising all hedge fund long U.S. equity portfolios that can examined using the filings. We analyzed HF Aggregate’s risk and its historical exposures relative to the U.S. Market. The top contributors to hedge fund industry’s relative risk are the industry’s most crowded bets. Factor exposures were analyzed using the AlphaBetaWorks (ABW) Statistical Equity Risk Model an effective predictor of future risk.

Hedge Fund Industrys Risk

The 9/30/2016 HF Aggregate had 3.9% estimated future volatility (tracking error) relative to the U.S. Market. Less than 20% of this risk came from individual stocks, or from stock-specific crowding; the remainder – more than 80% – came from factor (systematic) crowding:

Components of the Relative Risk for U.S. Hedge Fund Aggregate in Q3 2016

Source Volatility (ann. %) Share of Variance (%)
Factor 3.50 82.19
Residual 1.63 17.81
Total 3.86 100.00

Since residual risk accounts for just 18% of the total, basic analysis of hedge fund crowding that examines popular holdings and position overlap is misguided. Such stock-specific analysis of crowding covers less than 20% of the industry’s risk, overlooking the dominant 80% of hedge fund crowding that is due to factors – a fatal flaw. Even funds with no shared positions correlate highly when they have similar factor exposures, so simplistic analysis of popular holdings and of position overlap understates portfolio risk and fosters complacency.

Hedge Fund Factor (Systematic) Crowding

Below are HF Aggregate’s principal factor exposures (in red). The U.S. Market, defined as the iShares Russell 3000 ETF (IWV) is the Benchmark (in gray). These factors are the primary sources of risk in the table above:

Hedge Fund Crowding

Significant Absolute and Residual Factor Exposures of U.S. Hedge Fund Aggregate in Q3 2016

The dominant bet of hedge funds’ long equity portfolios is Market (high Beta):

Hedge Fund Crowding

Factors Contributing Most to Relative Factor Variance of U.S. Hedge Fund Aggregate in Q3 2016

Factor Relative Exposure Factor Volatility Share of Relative Factor Variance Share of Relative Total Variance
Market 20.65 10.59 46.19 37.97
Size -14.67 8.62 19.06 15.66
Health Care 12.68 7.54 16.22 13.33
Bond Index -19.34 3.37 8.94 7.35
Consumer Staples -7.87 7.24 5.28 4.34
Utilities -3.40 12.46 5.00 4.11
FX 10.70 6.80 -4.22 -3.47
Real Estate -1.86 12.80 2.97 2.44
Oil Price 1.03 30.15 2.75 2.26
Financials -4.84 7.05 -2.09 -1.72

(Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.)

This high U.S. Market exposure alone is twice as influential as all the stock-specific bets combined. Given this importance of factor crowding compared to residual crowding, popular fascination with fund holdings and position overlap is especially dangerous. Asset managers’ and allocators’ endurance thus depends increasingly on their edge in assessing systematic crowding.

Hedge Fund Short Bonds/Long Interest Rates Factor Crowding

HF Aggregate’s exposures to Market, Size, and Health Factors were near their peak levels seen in recent quarters. In addition to these, their Short Bonds/Long Interest Rates Factor exposure has also recently reached historic extremes:

Hedge Fund Crowding

U.S. Hedge Fund Aggregate’s U.S. Long Bonds/Short Interest Rates Factor Exposure History

We discussed the fundamental sources of this Bonds/Interest Rates Factor exposure in a prior article. Short bond risk is a natural consequence of hedge funds’ fondness for financially leveraged companies, often viewed as “cheap call options.” A company’s indebtedness creates economic and statistically observable short bond exposure. Given the Q4 2016 moves in yields, this bet should prove profitable for the hedge fund industry.

Hedge Fund Residual (Idiosyncratic) Crowding

A fifth of hedge fund crowding on 9/30/2016 was due to residual (idiosyncratic, stock-specific) risk. The following stocks were the main contributors to residual hedge fund crowding:

Hedge Fund Crowding

Stocks Contributing Most to Relative Residual Variance of U.S. Hedge Fund Aggregate in Q3 2016

Symbol Name Relative Exposure Residual Volatility Share of Relative Residual Variance Share of Relative Total Variance
LNG Cheniere Energy, Inc. 1.63 28.94 8.43 1.50
VRX Valeant Pharmaceuticals International Inc 0.89 43.63 5.76 1.02
AGN Allergan plc 1.86 18.17 4.32 0.77
WMB Williams Companies, Inc. 1.28 25.87 4.12 0.73
CHTR Charter Communications, Inc. Class A 1.69 19.27 4.01 0.71
FLT FleetCor Technologies, Inc. 1.62 17.40 3.02 0.54
AAPL Apple Inc. -1.90 14.29 2.78 0.50
EXPE Expedia, Inc. 1.04 24.57 2.47 0.44
BABA Alibaba Group Holding Ltd. Sponsored ADR 1.07 23.61 2.43 0.43
HCA HCA Holdings, Inc. 1.10 21.96 2.22 0.40

(Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.)

The importance of residual crowding diminished in recent quarters as factor crowding increased. Consequently, hedge fund stock-picking has faded in importance relative to market timing. The most crowded stocks are sensitive to asset flows in and out of the industry, but they are not the main threat to crowded portfolios. In the current environment of extreme systematic hedge fund crowding, investors and allocators should focus on the factor exposures. Without an accurate view of factor crowding, investors in a supposedly diversified hedge fund portfolio often end up paying high active fees for a passive factor portfolio.

Summary

  • At Q3 2016, over 80% of hedge fund industry’s relative long equity risk was due to factor, or systematic, crowding.
  • The main sources of Q3 2016 hedge fund crowding were high U.S. Market, short Size, long Health, and short Bonds/long Interest Rates Factor exposures.
  • Short Bonds/Long Interest Rates Factor exposure reached historic extremes.
  • Systematic exposures and risks shared across stocks, rather than individual positions, are driving 80% of the hedge fund industry’s long equity risk.
  • Only robust analysis of factor and residual crowding can determine whether a hedge fund investor, follower, or allocator is investing in exceptional insights or in a generic passive factor portfolio.

The information herein is not represented or warranted to be accurate, correct, complete or timely.

Past performance is no guarantee of future results.

Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.

Content may not be republished without express written consent.

Article by AlphaBetaWorks Insights



About the Author

ABW Insights
AlphaBetaWorks provides risk management, skill evaluation, and predictive performance analytics. Developed by finance and technology veterans, our proprietary platform combines the latest advances in financial risk modeling, data processing, and statistical analysis. Our Risk Analytics are more robust than alternatives and our Skill Analytics are predictive. Risk Analytics AlphaBetaWorks pinpoints risks missed by other offerings and delivers unique insights. AlphaBetaWorks Risk Analytics were developed by investment professionals seeking usability and a deeper understanding of portfolio exposures. Predictive Performance Analytics Starting with robust, proprietary risk models, AlphaBetaWorks adds layers of attribution and statistical analysis. Our Skill Analytics describe a multitude of specific skills that are strongly predictive of future returns for any fund, manager, or analyst with a sufficient sample of investment history. The AlphaBetaWorks Advantage Our Risk and Performance Analytics provide unique insights: For portfolio managers, we identify overlooked exposures, hidden risk clusters, and crowded bets. Managers can focus on risks in areas where they have proven ability to generate excess returns and avoid undesired risks in areas where they do not. For fund allocators, we identify the skills, crowding, and hidden portfolio bets of individual funds and portfolios of funds. Allocators can identify differentiated and skilled managers that are deploying capital in areas of proven expertise – and more importantly, those that are not. Background As finance professionals, we spent the last decade focused on fundamental investment analysis and the study of great (and seemingly great) investment managers. We asked of ourselves: Where are the unintended risks in a portfolio? What is the chance that a manager possesses true investment skill and was not just lucky? Does investment skill persist and is past skill a predictor of future results? There was no product, service, or technology that rigorously and consistently answered these questions. With decades of fundamental investment analysis, risk management, mathematics, and technology expertise, AlphaBetaWorks professionals have developed risk and skill analytics to address these and related questions.