Three weeks ago, just as Q3 earnings season was about to begin and ahead of a historic rout in the S&P, we showed a BofA screen of the top 20 longs and shorts held by hedge funds, which as we explained at the time is relevant because as we first discussed 5 years ago, the best performing strategy in the market has been also the simplest one: buying the most underweight stocks by large cap active funds and selling the most overweight stocks by large cap active funds has consistently generated alpha (although 2017 was the only year when this trend was bucked).
We left readers with a specific trade suggestion:
with earnings season about to start, traders may put the above data to good use as positioning risks are particularly acute during quarter-end rebalancing: the 10 most neglected stocks have outperformed the 10 most crowded stocks by an annualized spread of 85ppt on average during the first 15 days of each quarter since 2012. In other words, buying the 10 most underweight stocks and shorting the 10 most overweight remains the best source of alpha this decade.
Today, with almost two thirds of earnings reports behind us, Bank of America provides an update of not only how hedge fund portfolios have shifted in the past month, but also how this “strategy” has performed.
In short, anyone who followed our advice to short the top 10 most widely held stocks while going long the 10 most hated names would have generated a stunning 81% annualized return so far this earnings season, the highest since th 292% return in Q4 2015.
Solid returns aside for those who bet that hedge funds would once again stumble all over each other on the way to the exits as they ran away from names, mostly in the tech and growth sectors, that were priced to perfection, Bank of America also found that in its latest update of large cap fund holdings, where two-thirds of the assets are current as of end of 3Q, large cap active managers have made the biggest rotation from cyclical sectors to defensive sectors in data history since 2008 just ahead of earnings.
In particular, managers’ relative exposures to Consumer Discretionary, Industrials and Materials have fallen to more than one standard deviation below historical averages, and Discretionary (1.08x) and Industrials (0.91x) are now at record low levels of positioning.
At the same time as managers fled “sicklical” stocks they flooded into defensives, as managers’ overweight in Health Care has risen to its highest level of positioning in more than two years (1.08x to 1.13x), now more crowded than Discretionary and second only to Communication Services (1.28x). Staples positioning also rebounded from its record low level (0.68x) to a one-year high (0.72x). At the same time, utilities positioning jumped to its highest level in more than two years at 0.46x, and Real Estate is now at its record high levels of positioning at 0.44x. According to BofA, “this rotation couldn’t have been more timely, as the S&P 500 index almost saw a 10% correction in October and cyclicals/high risk stocks were hit the hardest, while the defensive/bond-proxy sectors outperformed.”
Unfortunately, this pre-emptive rotation was not enough, as stocks still overowned by active managers continued to suffer during the sell-off, as the top 25 crowded stocks underperformed the equal-weighted S&P 500 between Sept 20 and Oct 29 (peak-to-trough) by 3.5%, while the 25 least owned stocks outperformed the index by 5.3 ppt.
In other words, anyone who was long the 25 biggest hedge fund longs and short the 25 biggest shorts, generated a nearly 9% absolute return in the past month!
And, as noted above, positioning risk has been particularly acute following quarter ends, with the average annualized 15-day return spread post-quarter-end between the top vs. bottom 10 by relative weight since 2008 has been a remarkable 84ppt.
Finally, for those who missed the last boat but are hoping to profit from the increasing confusion among the “smart money”, BofA again screened for stocks with the most (Table 4) and the least (Table 5) short interest (as a % of float), where the most (~85%) short interest in stocks is from hedge funds. What the analysis found is that the most hated, or shorted, stocks are the following:
- Under Armour
- Discovery
- Campbell Soup
- Kohl’s Corporation
- Mattell
- Nordstrom
- Coty
- TripAdvisor
- Mircochip Technology
- Macy’s
Meanwhile, the least shorted names are, not surprisingly, the blue chips:
- JPMorgan
- Wells Fargo
- Johnson & Johnson
- UnitedHealth Group
- Microsoft
- PNC Financial
- Medtronic
- Berkshire Hathaway
- Coca-Cola
- Alphabet
The full list is below:
And to complete the hedge fund exposure picture, BofA also performed a screen of 1) stocks which are most overweight by hedge funds based on their net relative weight in the stocks vs. its weight in the S&P 500 and 2) a screen of stocks which have the largest net short positioning by hedge funds relative to the stocks’ weight in the S&P 500.
According to BofA, these are the 10 stocks where hedge funds have the most net relative exposure:
- Twenty-First Century Fox Class A
- IQVIA Holdings
- Incyte
- Arconic
- TransDigm
- NRG Energy
- Twenty-First Century Fox Class B
- Alliance Data Systems
- United Continental Holdings
- Xerox
While the 10 most net short names relative to net exposure are the following 10 companies:
- Mattell
- Hormel Foods
- Microchip Technology
- Albermarle
- Coty
- Discovery
- Nordstrom
- Under Armor
- Omnicom
- Iron Mountain
And summarized:
So when in doubt what trades to put on (and the latest Gartman reco is not available), the answer is simple:
Over the last several years, buying the most underweight stocks by large cap active funds and selling the most overweight stocks by large cap active funds has consistently generated alpha.
In other words, just keep doing the opposite of what the smart money has done: as the data repeatedly shows, in a world that is allegedly devoid of alpha, taking the other side of the “smart money” crowd has been the winning trade for 7 of the past 8 years.
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