Hedge Fund Crowding Update - Q3 2016

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Includes: AAPL, AGN, BABA, CHTR, EXPE, FLT, HCA, IWV, LNG, VRX, WMB
by: AlphaBetaWorks

Summary

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%.

Factor crowding has dominated the hedge fund industry’s absolute and relative returns.

Factor exposures shared by the entire hedge fund industry that can be obtained cheaply with passive funds do not warrant the same compensation as distinctive insights of gifted managers.

Understanding and quantifying this factor crowding is vital for hedge fund investors and allocators. This article reviews the most crowded factor and residual bets.

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 the hedge fund industry's relative risk are the industry's most crowded bets. Factor exposures were analyzed using the AlphaBetaWorks Statistical Equity Risk Model, an effective predictor of future risk.

Hedge Fund Industry's 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 (NYSEARCA:IWV), is the benchmark (in gray). These factors are the primary sources of risk in the table above:

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

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

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 with 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.

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:

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:

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

(NYSEMKT:LNG)

Cheniere Energy, Inc.

1.63

28.94

8.43

1.50

(NYSE:VRX)

Valeant Pharmaceuticals International Inc

0.89

43.63

5.76

1.02

(NYSE:AGN)

Allergan plc

1.86

18.17

4.32

0.77

(NYSE:WMB)

Williams Companies, Inc.

1.28

25.87

4.12

0.73

(NASDAQ:CHTR)

Charter Communications, Inc. Class A

1.69

19.27

4.01

0.71

(NYSE:FLT)

FleetCor Technologies, Inc.

1.62

17.40

3.02

0.54

(NASDAQ:AAPL)

Apple Inc.

-1.90

14.29

2.78

0.50

(NASDAQ:EXPE)

Expedia, Inc.

1.04

24.57

2.47

0.44

(NYSE:BABA)

Alibaba Group Holding Ltd. Sponsored ADR

1.07

23.61

2.43

0.43

(NYSE: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 © 2012-2017, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved. Content may not be republished without express written consent.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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