Most investors have probably seen the numerous headlines trumpeting the top finding from Goldman Sachs’ most recent “Hedge Fund Trend Monitor.” Hedge fund crowding is now at a record high, and many managers and investors have been riding high on that momentum for much of the year.
However, while all that crowding has been working very well for some, past studies suggest that extreme crowding may mean the time for greed may be long past — replaced by a need for fear.
Hedge fund crowding hits a record high
In their “Hedge Fund Trend Monitor” covering the third quarter, Goldman Sachs analysts reported that the typical hedge fund now holds 70% of its long portfolio in its top 10 positions. That reading matches the second-highest reading for concentration recorded since the firm started tracking it 22 years ago.
The only other time the bank observed higher concentration among hedge funds was in the fourth quarter of 2018. Additionally, the firm reported that the third quarter saw the highest level of crowding among hedge fund long portfolios in the 22 years it has been keeping data on this.
All that crowding has been a key positive for fund managers and the investors who track their holdings. In fact, Goldman’s basket of the most popular hedge fund positions is up 31% year to date, led by the so-called “Magnificent Seven” (Alphabet, Apple
Riding high on the Momentum factor
Unsurprisingly, the combination of high crowding in Big Tech names and Big Tech’s outperformance gave hedge funds a near-record tilt toward the Momentum factor.
In 2022, funds maintained the large positions they had in tech and other growth stocks—even though those stocks underperformed sharply. The result was a record anti-Momentum tilt among hedge funds last year. However, that tilt has reversed and shifted all the way to a near-record tilt toward Momentum as tech stocks recaptured their market leadership throughout the year.
Additionally, the long hedge fund portfolio tilt toward Growth versus value has climbed steadily in recent quarters, reaching the highest level since late 2020.
A warning about crowding
Of course, there are reasons many investors track hedge fund holdings with their portfolio. In fact, the basket of the most popular hedge fund long positions has outperformed in 59% of quarters since 2001, with a quarterly excess return of 43 basis points. However, when crowding soars to record high levels like it did recently, investors should beware.
Researchers have studied what happens when hedge fund crowding soars. While it can be hugely beneficial and gratifying to ride that momentum all the way up, what goes up usually comes down, and when it comes to crowded stocks, the crash tends to be spectacular.
One study conducted by three business school professors and published in 2019 revealed that crowded stocks fall harder than everything else when the next selloff arrives. In their study entitled “Crowded Trades and Tail Risk,” they wrote that “the crowdedness of an equity position is an important ingredient for characterizing risk.”
For example, late 2018 saw the most popular stocks among hedge funds plummet many times more than those with the least hedge-fund ownership. Research into this dynamic has increased in recent years as assets under management by hedge funds have risen almost tenfold over the last two decades.
In their study, the professors did find that crowded stocks tend to do better over time. They discovered that a market-cap-weighted portfolio of the stocks most owned by hedge funds returned an average of almost three percentage points more than those with the least ownership.
In fact, the professors described the advantage of crowdedness as a sort of “quant” factor, equating it to other factors like Momentum. However, they also clarified that stocks with high crowding among hedge funds display significant differences that can’t be explained by existing factors normally based on risk.
The business professors also clarified that with the higher returns also comes increased risk. They found that the most crowded stocks plunge during market selloffs, something observed during the Great Financial Crisis. The professors linked crowdedness with downside tail risk because stocks with significant crowding experienced larger drawdowns during turbulent periods in the market.
Zeroing in specifically on the selloff in October 2018 and citing data from UBS, BNN Bloomberg noted that the stocks with the highest ownership among hedge funds or exchange-traded funds saw four times the losses recorded in the S&P 500.
The following month, there was evidence that hedge funds had become net sellers of tech stocks after jumping back into those names in late October, which further added to the downward pressure on those stocks in late 2018.
A deteriorating stock-picking environment
For now, the equity markets seem to be humming right along, and traders who are tracking hedge fund portfolios may be laughing all the way to the bank. However, despite the tech-driven gains in the equity market, this has certainly been a volatile year with lots of ups and downs.
In fact, Goldman reported in its latest “Hedge Fund Trend Monitor” that the stock-picking environment has actually deteriorated this year — despite the year-to-date gains of 20% in the S&P 500 and 37% in the Nasdaq Composite.
According to the report, the outperformance of the most popular hedge fund positions and the underperformance of the most popular shorts have been supporting equity returns, making the stock-picking environment almost seem like it’s not so bad.
In fact, the outperformance of the popular hedge fund positions has persisted despite the increasing volatility in recent months. However, the firm added that the improvement in the alpha-generation backdrop that occurred earlier this year has now reversed, sending the “micro” share of stock returns downward in the fourth quarter and boosting the equity market’s macro factors.
Signs of the deteriorating stock-picking environment
For many investors, the robust year-to-date gains in the key indexes might be all they need to see a bull market in action. However, Goldman Sachs shared some evidence of the deterioration it observed in the stock-picking environment.
Since mid-2022, stock pickers have enjoyed a steadily improving environment for alpha generation, which helped explain the rising gross exposures among hedge funds, which started to focus on alpha over beta. Then in early 2023, stock returns became more micro-driven than they had been since late 2017, but that dynamic has begun to reverse here in the fourth quarter, sending the macro portion of stock returns higher.
According to the report, rising stock correlations and falling return dispersion also reflect the increasingly challenging environment for stock picking. The average correlations for S&P 500 stocks plunged sharply throughout much of this year before bouncing back to their long-term averages in recent months.
Additionally, return dispersion, which Goldman measures as the cross-sectional distribution of returns across S&P 500 stocks, was above average earlier this year, which indicated a positive alpha-generation environment. However, return dispersion has just recently begun to decline.
Trend reversal for Magnificent Seven
We may already be seeing harbingers of potential trouble in the near future by looking at Big Tech. Notably, the dynamics around the Magnificent Seven have changed rapidly — significantly impacting hedge fund portfolios in the process. While these Big Tech names boosted hedge fund portfolios earlier this year as they outperformed, they stalled during the third quarter. As a result, their portfolio weights doubled from where they stood at the beginning of the year.
During the third quarter, the Magnificent Seven accounted for 13% of the U.S. hedge fund long equity portfolio. Meanwhile, all but Tesla ranked among the top 10 of Goldman’s list of the most popular hedge fund long positions.
Due to the rapid increase in the weightings of the Magnificent Seven in hedge fund portfolios, it comes as little surprise that this trend reversed sharply in the week that ended on Nov. 24. Goldman Sachs’ prime brokerage segment reported that hedge funds sold the largest volume of tech and media stocks observed since July.
In fact, by the end of that week, communication and information technology stocks were the most net sold at the bank’s prime brokerage trading desk. Additionally, the firm said hedge funds that had been long those stocks dropped their bets at the fastest rate in almost eight months.
As mentioned above, hedge funds became net sellers of tech stocks amid the late-2018 selloff after temporarily bouncing back into those names, increasing the downward pressure on tech. Of course, it’s too early to determine just when the next bear market might occur, but it won’t hurt to watch and wait.
In June, Jim Rogers warned that the next bear market would be the “worst in his lifetime,” even bigger than the 2008 crash. He added that the high levels of debt were responsible for the 2008 crash, and today, those high debt levels are back.
Seeking alpha in a poor stock-picking environment
Ultimately, Goldman Sachs suggested that investors seeking opportunities for alpha should look at “controversial” stocks, which are in the top 20% of both the most popular hedge fund stocks and the highest short interest relative to market cap.
The top 10 most “controversial stocks” from the third quarter are listed as Lyft, RH, Wayfair, Advance Auto Parts