Written by AlphaBetaWorks Insights
The Virtuous and Vicious Cycles of Crowding
Hedge Fund Crowding has cost investors $12 billion in the first 10 months of 2015, and $9 billion in the August-October 2015 rout. That is to say, tractable hedge funds’ long U.S. equity portfolios have suffered severely negative active return from security selection (alpha, or ?Return) this year, and the liquidation has accelerated. Even ignoring fees, had hedge fund investors taken the same risks passively, they would have made $20 billion more since the winds turned in late 2014.
Crowding can be either a good thing or a bad thing: Net flows into crowded names can create positive alpha, typically gradually.However, liquidation of crowded longs is often rapid and painful.Indeed, the latter has been the case since 2014. In the face of these outflows, identifying and avoiding crowded bets is more vital than ever for fund managers, and choosing differentiated managers is more vital than ever for allocators.
Hedge Fund Alpha from Crowding
Below is a chart of the cumulative risk-adjusted return from security selection (alpha, or ?Return) of the AlphaBetaWorks’ Hedge Fund Aggregate, or HF Aggregate (a detailed discussion of crowding and our methodology is at the end of this piece):
Cumulative Return from Security Selection of U.S. Hedge Fund Aggregate
Note the three distinct states of alpha generation for HF Aggregate: positive alpha from 2005 through late 2010, zero alpha (flat) from 2011 to mid-2014, and severely negative alpha from mid-2014 through late-2015. The decline from the 2009-2014 plateau is nearly $23 billion, which makes recent losses nearly 1.5 times greater than gains from the prior nine years.
Several more observations from the chart above are worth discussing:
First, HF Aggregate did not record severe negative alpha in 2008. Not surprisingly, negative nominal hedge fund long returns during this era were systematic, rather than idiosyncratic returns from security selection. However, numerous sectors within HF Aggregate experienced severe liquidations, some of which we have discussed in our prior work.
Second, the severity of the most-recent liquidation of crowded names is stunning. Accumulation is usually gradual. But liquidations tend to gather steam quickly when crowded stocks and hedge funds underperform. The severity of the most recent liquidation of crowded hedge fund names is historically unprecedented.
The key lesson here, for both hedge fund managers and allocators, is to know whether crowding is your friend or enemy. If crowding is your friend, enjoy the virtuous cycle but be wary.If it is your enemy, beware of the vicious cycle but be opportunistic. In individual sectors, forced liquidations do tend to end with mean-reversions: the biggest losers can eventually present attractive opportunities.
