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Anne Ford on the ugly downside to managers falling in love with the same stocks

Hedge fund investors have been in the doldrums lately.

Since market volatility increased last summer after a period of relative calm, hedge fund managers have been whipsawed around trying to navigate choppy waters.

The HFRI Composite index has fallen 4 per cent since the second quarter of 2015, underperforming the S&P 500 index by 6 per cent, and started 2016 off with the worst January since 2008.

While those returns are poor, they are by no means the worst of it. Funds that piled into the most crowded hedge fund names were hit much harder. According to data compiled by Bloomberg since July 2015, stocks in which hedge funds had the largest ownership percentage in the Russell 3000 index fell a whopping 31 per cent.

For investors in multi-manager portfolios with overlapping exposures, the effects were amplified as they sometimes doubled down unintentionally on these crowded names.

In a benign market environment, duplicated positions are not uncommon and are, perhaps, inevitable. In fact, if managers are drawn to the same stocks, it may validate the investment thesis and can be a positive for investors.

The ugly downside to managers falling in love with the same stocks is that it contributes to liquidity risk in times of market stress. When hedge fund managers who own a large portion of the total trading volume are all trying to sell at the same time, it becomes a vicious cycle of de-risking regardless of fundamentals.

This is what happened in February when hedge funds experienced the worst 10-day period of relative performance since 2011 and found themselves held hostage as they blew through their risk parameters.

Given the recent turmoil, some investors are surmising that the bloated hedge fund industry has lost its way, with too much capital chasing too few ideas. The industry is now roughly $3tn in size, having grown considerably since the financial crisis.

Other investors have the exact opposite claim, pointing out that recent hedge fund redemptions have created forced selling and reduced liquidity for investors in crowded hedge fund names.

A March 15 Bloomberg article pointed out that hedge fund clients of Bank of America sold a net $3.5bn in equities so far this year, larger than any other type of seller.

The reality is that investors crowding into popular stocks is nothing new. When the markets are ripping, investors are happy to follow the “smart money” trades on the way up, even if they are crowded.

Over time, it has been beneficial to invest in the most popular stocks. Goldman Sachs’s Equity Research Group maintains a hedge fund VIP basket that tracks the 50 most popular hedge fund long positions.

Since 2001, to February 19, the VIP list has outperformed the S&P 500 index in 64 per cent of quarters by an average of 56 basis points, or 225bp annualised.

Regardless of the long-term positives, investors can get burnt in the short term by crowded trades as managers de-risk and head for the exit. The GS VIP was hurt in 2002, 2008, 2011 and 2015, all periods when volatility spiked in times of economic stress.

With uncertainty over US interest rate policy, Chinese growth and oil prices, volatility could remain elevated in the near term, putting hedge funds with crowded positions under further pressure.

Investment advisers and multi-manager strategies such as fund of funds will also be under pressure as they struggle to justify their fees and prove that they are avoiding “group think”.

It will be ever more important for advisers to look under the hood of hedge funds, performing robust diligence to understand their managers’ thought processes. It is not enough to just rubber stamp a manager because they have sizeable assets and are well known in the industry.

The key is finding those who have real conviction in their investments and avoid those who have made a name by simply following the herd.