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The Most Crowded Hedge Fund Bets At Year-End 2015

Most analyses of hedge fund crowding focus on their residual (idiosyncratic, stock-specific) bets. This is misguided, since over 85% of the monthly return variance for the majority of hedge fund long equity portfolios is due to factor (systematic) exposures, rather than individual stocks. Indeed, it is the exceptional factor crowding and the record market risk that have driven much of the industry’s recent misery (just as they have driven much of the earlier upswings). In Q4 2015, a single factor accounted for half of U.S. hedge funds’ relative long equity risk. We survey all sources of hedge fund crowding at year-end 2015 and identify the market regimes that would generate the highest relative outperformance and underperformance for the crowded factor portfolio. These are the regimes that would most benefit or hurt hedge fund investors and followers. Identifying Hedge Fund Crowding This piece follows the approach of our earlier articles on crowding : We processed regulatory filings of over 1,000 hedge funds and created a position-weighted portfolio ( HF Aggregate ) consisting of all the tractable hedge fund long U.S. equity portfolios. We then analyzed HF Aggregate’s risk relative to U.S. Market using the AlphaBetaWorks Statistical Equity Risk Model – a proven system for performance forecasting . The top contributors to HF Aggregate’s relative risk are the most crowded hedge fund bets. Hedge Fund Aggregate’s Risk The Q4 2015 HF Aggregate had 3.7% estimated future tracking error relative to U.S. Market; over two thirds of this was due to factor ( systematic ) exposures : Components of the Relative Risk for U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Source Volatility (ann. %) Share of Variance (%) Factor 3.10 69.07 Residual 2.08 30.93 Total 3.73 100.00 Simplistic analysis of hedge fund crowding that lacks a capable risk model will miss these systematic exposures. Among its flows, this comparison of holdings will overlook funds with no position overlap but high future correlation due to similar factor exposures. Hence, this simplistic analysis of hedge fund crowding fosters dangerous complacency. Hedge Fund Factor (Systematic) Crowding Factor exposures drove nearly 70% of the relative risk of HF Aggregate at year-end 2015. Below are the principal factor exposures (in red) relative to U.S. Market’s exposures (in gray): Significant Absolute and Residual Factor Exposures of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Of these bets, Market (Beta) alone accounts for two thirds of the relative and half of the total factor risk, as illustrated below: Factors Contributing Most to Relative Factor Variance of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Factor Relative Exposure Factor Volatility Share of Relative Factor Variance Share of Relative Total Variance Market 18.27 12.46 68.12 47.05 Oil Price 2.28 29.43 13.08 9.04 Bond Index -7.53 3.33 4.97 3.43 Utilities -3.10 11.28 4.77 3.30 Consumer -8.30 3.75 3.54 2.44 Energy -3.21 11.77 -2.96 -2.04 Health 4.79 7.22 2.54 1.75 Communications -1.67 11.98 1.91 1.32 Finance -6.89 5.08 1.68 1.16 Size -1.96 8.09 1.34 0.92 (Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.) Thus, the most important source of hedge fund crowding is not a stock or a group of stocks, but systematic exposure to the U.S. Market Factor . When nearly half of the industry’s risk comes from a single Factor, fixation on the individual crowded stocks is particularly dangerous. The U.S. Market crowding alone explains much of the recent industry misery. In this era of systematic crowding, risk management with a robust and predictive factor model is particularly vital for managers’ and allocators’ survival. Hedge Fund Factor Crowding Stress Tests Hedge Fund Crowding Maximum Outperformance Given Hedge Fund Aggregate’s bullish macroeconomic positioning (Long Market, Short Bonds/Long Interest Rates), it would experience its highest outperformance in an environment similar to the March-2009 rally. In this scenario, HF Aggregate’s factor portfolio would outperform by 20%: Historical Scenario that Would Generate the Highest Relative Performance for the Q4 2015 U.S. Hedge Fund Aggregate Click to enlarge Source: abwinsights.com The top contributors to this outperformance would be the following exposures: Factor Return Portfolio Exposure Benchmark Exposure Relative Exposure Portfolio Return Benchmark Return Relative Return Market 66.04 120.07 101.80 18.27 83.00 67.50 15.50 Oil Price 87.13 1.53 -0.75 2.28 1.05 -0.51 1.56 Bond Index -6.29 -4.92 2.61 -7.53 0.31 -0.17 0.48 Energy -12.54 1.61 4.82 -3.21 -0.20 -0.61 0.41 Communications -17.62 0.52 2.19 -1.67 -0.10 -0.41 0.31 Hedge Fund Crowding Maximum Underperformance Given Hedge Fund Aggregate’s bullish macroeconomic positioning, combined with a long Technology and short Finance exposures, it would experience its highest underperformance in an environment similar to the 2000-2001 .com Crash. In this scenario, HF Aggregate’s factor portfolio would underperform by 8%: Historical Scenario that Would Generate the Lowest Relative Performance for the Q4 2015 U.S. Hedge Fund Aggregate Click to enlarge Source: abwinsights.com The top contributors to this underperformance would be the following exposures: Factor Return Portfolio Exposure Benchmark Exposure Relative Exposure Portfolio Return Benchmark Return Relative Return Finance 47.97 12.48 19.36 -6.89 5.27 8.26 -2.99 Market -14.21 120.07 101.80 18.27 -17.22 -14.48 -2.74 Technology -36.73 23.75 20.14 3.62 -9.83 -8.38 -1.45 Utilities 52.32 0.22 3.31 -3.10 0.10 1.51 -1.42 Consumer 12.36 14.87 23.17 -8.30 1.82 2.85 -1.02 Hedge Fund Residual (Idiosyncratic) Crowding A third of the year-end 2015 hedge fund crowding is due to residual ( idiosyncratic, stock-specific) risk. Valeant Pharmaceuticals International and Netflix are responsible for nearly half of it: Stocks Contributing Most to Relative Residual Variance of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Though there may be sound individual reasons for these investments, they are vulnerable to brutal liquidation. Given the recent damage to hedge funds from herding, these crowded residual bets remain vulnerable: Symbol Name Relative Exposure Residual Volatility Share of Relative Residual Variance Share of Relative Total Variance (NYSE: VRX ) Valeant Pharmaceuticals International, Inc. 2.67 43.72 31.56 9.76 (NASDAQ: NFLX ) Netflix, Inc. 1.57 54.62 17.15 5.30 (NASDAQ: JD ) JD.com, Inc. Sponsored ADR Class A 1.60 31.91 6.05 1.87 (NYSEMKT: LNG ) Cheniere Energy, Inc. 1.38 33.35 4.88 1.51 (NASDAQ: CHTR ) Charter Communications, Inc. Class A 1.79 20.31 3.08 0.95 (NYSE: TWC ) Time Warner Cable Inc. 1.85 16.14 2.06 0.64 (NYSE: AGN ) Allergan plc 1.83 14.62 1.66 0.51 (NYSE: FLT ) FleetCor Technologies, Inc. 1.18 19.61 1.23 0.38 (NASDAQ: PCLN ) Priceline Group Inc 1.12 20.10 1.18 0.36 (NASDAQ: MSFT ) Microsoft Corporation 1.54 14.13 1.10 0.34 (Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.) Though stock-specific bets remain important, allocators and fund followers should pay particular attention to their factor exposures in the current environment of extreme systematic hedge fund crowding. Many may be effectively invested in leveraged passive index fund portfolio, with the added insult of high fees. AlphaBetaWorks Analytics address all of these needs with the coverage of market-wide and sector-specific herding, plus aggregate factor exposures of funds and portfolios of funds. Summary The main source of Q4 2015 hedge fund crowding, responsible for nearly half of the relative long equity risk, was record U.S. Market exposure. The main sources of Q4 2015 residual crowding were VRX and NFLX. Given the high factor (systematic) crowding among hedge funds’ long equity portfolios, current analysis of crowding risks must focus on the factor exposures, rather than individual positions. The information herein is not represented or warranted to be accurate, correct, complete or timely. Past performance is no guarantee of future results. Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved. Content may not be republished without express written consent. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Should You Buy A Company After A Dividend Cut?

By Rupert Hargreaves Should you buy a company after it has cut its dividend? That’s the question Morgan Stanley’s analysts have tried to answer in a European Equity Strategy research note sent to clients today and reviewed by ValueWalk. Morgan’s research has been prompted by renewed investor interest in dividend cuts. Against a depressed earnings base, the market’s dividend payout level looks high in a historical context and the median stock’s payout ratio is close to a 20-year high. On a pan-European level, the payout ratio has exceeded 2009 levels. It’s also important to note that this is not an anomaly that is limited to a few key sectors, the percentage of stocks with a payout ratio in excess of 60% of earnings per share has reached the highest level in 20 years. Click to enlarge As European investors have seen over the past few months, even those companies that were considered dividend aristocrats aren’t in any way immune from payout cuts, with companies like Rolls Royce ( OTCPK:RYCEF ), BHP (NYSE: BHP ), EDF, RWE ( OTCPK:RWEOY ) and Repsol ( OTCQX:REPYY ) all cutting their dividends during the past six months. An updated study This isn’t the first time Morgan has investigated this question. Back in 2008, the bank conducted a similar research exercise and found that dividend cuts can indicate powerful inflection points in share prices. At the time, the research showed that investors could do well by buying stocks on dividend reductions, particularly those that are stressed. In the 2008 version, Morgan’s research showed that UK companies that cut their dividend tended to outperform thereafter, especially if the shares had previously been poor performers, the payout cut was large or the starting yield was high. Click to enlarge In this updated version, Morgan examines 372 instances of dividend cuts in Europe over the last ten years. The stocks are based on the current constituents of MSCI Europe IMI, with a current market cap bigger than $2 billion. To qualify as a dividend cut, the company’s dividend payout has to be reduced by 5% or more. Should you buy a company after a dividend cut? The results of this study are rather interesting. It appears that dividend cuts are indeed, often inflection points for stock performance. Morgan’s research on the 372 instances of dividend cuts in Europe over the last ten years shows that the median stock underperforms the market by 19% in the preceding 12 months but then outperforms by 11% in the subsequent 12 months, and by 19% by the end of year two. The probability of a stock beating the market in the following 12 months after a dividend cut is 65%, and 66% of the subsequent 24 months. Click to enlarge The research also showed that the strongest outperformance comes from stocks where the dividend yield ahead of the cut was 12% or higher with a hit ratio of 83% in the subsequent 12 months and 88% in the following 24 months. The weakest performance came from stocks trading on a dividend yield of 4% to 6% ahead of the announced cut. Stocks that underperformed the market ahead of the dividend cut announcement tended to outperform the most after a cut. Among the stocks that underperformed more than 60% prior to the cut, 74% outperformed on a 12m basis and 86% outperformed on a 24m basis. The weakest subsequent performance came from the group that underperformed less than 20%, with a hit ratio of 61%, even on a two-year basis. Click to enlarge And lastly, the size of the dividend cut has an effect on performance after the event. In the 372 cases studied by Morgan’s analysts, the average dividend cut is more than 80%. Stocks that cut their payouts by more than 60% outperformed the most post the cut. The weakest performing group is the one that cut the dividend by 20% to 40% – even on a 2-year view, only 56% of such companies outperformed the market. Click to enlarge Dividend Cut – The bottom line All in all, this analysis from Morgan presents a pretty compelling argument: investors should buy stocks on dividend cuts, particularly those that have underperformed significantly ahead of the announced dividend cut, that previously had a very high yield, and those that cut their dividend by 60% or more. This analysis is aimed at European investors and Morgan also provide some investment ideas in the form of stocks that cut their dividends in the last year and are ‘stressed’. Click to enlarge Disclosure: None