Monday, September 29, 2014

Hedge Funds All Seem to be In the Same Crowded Trades

From AlphaBetaWorks:

Hedge Fund Crowding – Q2 2014

Extraordinary Popular Delusions and the Madness of Crowding

U.S. hedge funds share a few systemic and stock-specific long bets. These crowded bets are the main sources of aggregate long hedge fund relative performance as well as many individual funds’ returns. Two risk factors and six stocks are behind most of this herding. The crowded stocks may experience elevated volatility due to the congestion of their hedge fund investor base. The returns of these consensus bets may also disappoint.
Hedge fund crowding consist of:
  1. High-beta bets,
  2. Small-cap bets, and
  3. A handful of individual stocks.
Combined, these account for two thirds of the aggregate long hedge fund risk relative to the market.

Identifying Crowding

We created an aggregate position-weighted portfolio (HF Aggregate) consisting of over 200 popular securities held by over 400 U.S. hedge funds with medium to low turnover: If at least ten funds owned a particular security, we included it in HF Aggregate. Within HF Aggregate, the size of each position is the dollar value of its ownership by the funds.
We then evaluated the risk profile of HF Aggregate relative to the U.S. Market (Russell 3000) using AlphaBetaWorks’ Statistical Equity Risk Model and looked for evidence of crowding. Finally, we analyzed risk and calculated the tracking error of each fund relative to HF Aggregate to see which funds most closely resemble it.

Hedge Fund Aggregate Risk

HF Aggregate has approximately 3% estimated future tracking error relative to the market. Risk is evenly split between factor (systemic) and residual (idiosyncratic) bets:
Chart of the sources of relative variance of  U.S. hedge fund aggregate portfolio
Sources of Relative Risk for U.S. Hedge Fund Aggregate
Source Volatility (%) Share of Variance (%)
Factor 2.48 55.51
Residual 2.22 44.49
Total 3.32 100.00
With a forecasted relative tracking error near 3%, HF Aggregate will have a very hard time earning a typical fee (1.5% management fee plus incentive). HF Aggregate is nearly passive. Even if one is not concerned with hedge fund closet indexing, investing in a broadly diversified portfolio of long-biased hedge funds is a bad idea.

Hedge Fund Factor (Systemic) Crowding

Below are HF Aggregate’s (red) most significant factor exposures relative to U.S. Market (grey).....MORE
HT: Market Folly