Swedroe: Crowded Trades & Tail Risk

March 01, 2019

Over the last 20 years, the hedge fund industry has grown from a few hundred funds with an estimated $400 billion in assets under management (AUM) to several thousand funds with an estimated $3.2 trillion in AUM.

Hedge funds are fairly unique investors because they: (1) tend to be particularly active in seeking alpha; (2) often take highly concentrated positions; (3) are often run by managers who were trained on similar investment styles and therefore tend to seek similar investments in factors uncovered by academic research; and (4) use leverage and short sales.

Worth noting is that over the last 20 years, the number of publicly listed companies in the U.S. has declined by about 50% from nearly 8,000 in 1997 to under 4,000 in 2017. The result is that the universe of opportunities for hedge fund trades has shrunk significantly even as the number of funds and size of assets has grown.

These facts all make the study of hedge fund positions a good laboratory for understanding the role of active traders in creating risks associated with crowded trades.

Crowded Trades

We can define a crowded trade as a collection of similar positions in a particular asset by investors who share a common investment thesis and may therefore want to trade in the same direction at about the same time. Such trades run the risk of “fire sales,” which occur when a large investor(s) wants to sell significant amounts of an asset, and there are insufficient buys near the current market price. Financial crises, such as the failure of Lehman Brothers, often lead to fire sales.

Gregory Brown, Philip Howard and Christian Lundblad, authors of the February 2019 study “Crowded Trades and Tail Risk” sought to understand how concentrated positions held by hedge funds create risks and how they affect asset and portfolio returns. Their focus was on long positions in U.S. equities held by about 1,500 hedge funds from 2004 through 2016. Because crowdedness does not have a single widely accepted definition, they measure it in four ways.

  • The value of holdings by hedge funds. For the average stock hedge fund, holdings grew more than threefold, from about $160 million in 2004 to over $500 million in 2016.
  • The number of hedge funds invested in each stock. The number of funds holding a typical stock has roughly doubled from 15 in 2004 to 28 in 2016.
  • The percentage of shares outstanding (PSO) held by hedge funds. Average PSO increased from about 8% in 2004 to 12% in 2016.
  • Hedge fund holdings as a percentage of average daily trading volume (days-ADV). This is likely the best measure of the ones we consider, because it measures crowdedness in terms of the size of hedge fund holdings as well as the underlying liquidity of the stock. The days-ADV increased from about 18 days in 2004 to 26 days in 2016.

Quintile Analysis

Brown, Howard and Lundblad then sorted stocks into quintile portfolios based on the cross-sectional variation of each measure. As is common practice, “To limit the contaminating effects of difficult to trade micro-capitalization stocks, the smallest 20% of securities over the sample period are removed from the sample,” they wrote. The data sample constituted almost 6,000 securities. Following is a summary of their findings:

  • In each measure, the most crowded portfolios have the highest returns, and the least crowded portfolios have the lowest returns. On a value-weighted basis sorted on days-ADV, the low crowdedness portfolio (Q1) average return is 8.5% per annum versus 11.3% for the high crowdedness portfolio (Q5). The difference of 2.8% was highly significant (t-stat of 6.2). The difference was much larger on an equal-weighted basis: 9.1% with a t-stat of 8.0.
  • The crowdedness factor generates, on average, statistically significant alphas even after controlling for other traditional risk factors, including the relative illiquidity of the more crowded positions.
  • At a particular point in time, some hedge funds are disproportionately invested in relatively crowded positions, whereas others are not.
  • The difference between high and low illiquidity portfolios is positive and significant for the equal-weighted portfolio (even with the removal of the smallest 20% of stocks). Illiquidity matters.
  • Constituent stocks are relatively sticky—transition probabilities of firms across portfolios are reasonably low. Taking the equally weighted days-ADV-based portfolios as an example, conditional on a firm being in portfolio Q1 (Q5), the likelihood of remaining there in the next period is 77% (82%).
  • High PSO or (Q5) firms are significantly smaller and less liquid, on average, than firms in the low crowdedness portfolios (Q1).
  • Some hedge funds disproportionately load on our crowdedness factor, others less so. For example, 58% of equity funds have significant exposures to crowdedness, while only 18% of global macro funds have significant exposures.
  • Firms with relatively higher exposures to crowdedness exhibit greater realized volatilities during the financial crisis. And they become relatively more correlated with peers holding similar investment positions. In bad states of the world (times of market turmoil), funds holding crowded securities, on average, become riskier.

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