Back in 2013, when hedge funds were just starting to realize that something is fundamentally broken in the current “market”, in which few if any active participants were able to consistently generate alpha as a result of central bank nationalization of capital markets, we laid out simply and succinctly what the “Best Trading Strategy” in this market was, namely “buying The Most Hated Names and shorting the Most widely-held ones.” And, as we documented year after year, this simple strategy generated outsized alpha every single year… until 2017.
This quirk was also noticed today by Bank of America’s Savita Subramanian, who in a report on fund positioning confirms that “over the last several years, buying the most underweight stocks and selling the most overweight stocks has consistently generated alpha, although performance in 2017 has bucked the trend.”
And while 2017 appeared to be an outlier in this trend of betting against crowded trades, Subramanian cautions that this divergence will hardly last into the new 2018, to wit: “History suggests one should watch out for crowded stocks at the beginning of the year: based on our data since 2009, the 10 most overweight stocks have lagged the 10 most underweight stocks on average by 57bp and 117bp during the first 15 and 30 calendar days of the year, respectively.”
The biggest risk, according to the BofA strategist is that after Dec. 31, fund managers “tend to rebalance after year-end,” something which they already did to an extent late in 2017:
We already saw some of this trade shortly after the strong style reversal since Nov 27, when neglected stocks outperformed crowded stocks by almost a full percentage point over the next two weeks. However, this spread was subsequently wiped out ahead of December 31, suggesting that crowding risks may remain ahead of the tendency for asset allocators and PMs to rebalance after year-end.
Looking at a sector breakdown, it will not come as news to anyone that over the past year the entire fund community has bought up tech names. As 13F after 13F season has shown, large cap funds hit record overweights in Tech several times last year, and Tech overtook Discretionary as the most crowded sector. This is a two-edged sword: while on one hand, this massive crowding helped funds finish the year with the highest hit rate in 8 years (48.1%), as Tech accounted for 38% of the S&P 500’s returns in 2017, the unwind – which has yet to come – will be especially violent and painful.
It’s not just tech names however: several other sectors where there has been abnormal changes in fund positioning in recent months are financials and real estate, consumer, and energy and materials:
- Financials and Real Estate: With the sector expected to benefit from tax reform and deregulation, Financials have emerged from a 15-month long underweight in 2017 to hit the benchmark (S&P 500) weight, driven by Banks and Capital Markets. Broken out from Financials as its own sector in 2016, Real Estate saw the biggest increase in exposure across sectors in 2017, with its relative weight rising from .33x a year ago to .40x today — the highest level in our data history since 2009.
- Consumer: PMs cut back on Discretionary and Staples exposure throughout 2017, with relative weight in Discretionary today at an 18-month low and Staples at its lowest level since 2009.
- Energy and Materials: These two sectors saw the biggest drop in relative weight last year as managers continued to shun commodity exposure. The relative weight in Energy has dropped from .87x a year ago to .76x (although is neutral on a beta adjusted basis); and Materials dropped from .95x to .86x today, its lowest level since 2009.
So going back to BofA’s original warning, namely that it is a dangerous time for the most crowded longs, here is the bank’s analysis of the 10 stocks active funds have the most and least exposure to as of this moment.
Again, Subramanian’s warning is that should there be a violent unwind – and one is long overdue – the most crowded stocks will be hit the hardest, while predictably the “least loved” stocks will outperform.
Or perhaps not, because at the current rate, active funds may no longer be the marginal decision – and price – makers for stocks. As the following charts show, not only is the exodus of funds out of active (and into passive) vehicles accelerating – with passive winning and active losing for most of the last 9 yrs – but the cumulative outflows from active funds since the great financial crisis are now approaching $1 trillion dollars, offset by $2 trillion in inflows into passive funds.
If that is indeed the case, the only differentiating factor is how much faster will retail investors dump funds into stocks, which as we first warned one year ago, are being sold by institutions, private clients and other smart money at an unprecedented pace to “mom and pop” investors across the US.
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