The Hedge Fund Herd Mentality, Piggybacking & Crowded Trades ~ market folly

Tuesday, June 15, 2010

The Hedge Fund Herd Mentality, Piggybacking & Crowded Trades

Loosely defined, the hedge fund 'herd mentality' is when various investment managers seemingly all invest in the same stocks. It's a trend that has occurred for years and is exemplified via Goldman Sachs' VIP list of stocks that are most commonly owned by hedge funds. It is the epitome of groupthink and can often lead to explosive situations. After all, hedgies are often perceived as primal creatures, each grasping for every basis point of performance. So, why should you be concerned with the herd mentality? Well, probably because prominent fund manager Dan Loeb is concerned about it and is taking what little steps he can to prevent it.

Earlier this morning, we posted up hedge fund Third Point's latest investor letter. In it, we got a glimpse at their portfolio, latest allocations, and manager Dan Loeb's frustration with regulators. However, none of that was as intriguing as a footnote he made on page five of his letter.

In the section regarding equity investments in Third Point's letter, Loeb writes, "Please note that we will no longer discuss investments made prior to our public 13-F filings. We have found that discussing our ideas may result in 'piling on' by other hedge funds who may subsequently sell at inopportune times resulting in greater hedge fund concentration and volatility, which is not in the interest of our investors."

Basically, he is stating that if his firm makes a new investment, investors (and everyone else) won't find out about this position until it becomes public at least forty-five days after they've established the stake. As we've detailed countless times in our hedge fund portfolio tracking series, 13F's are filed with the SEC on a time-lagged basis. For instance, the most recent filings we've covered for the first quarter were filed around May 15th, 2010 but reflect hedge fund positions as of March 31st, 2010. In the past, we'd learned about some of Loeb's new investments via his investor letters. But alas, no longer. It's a good thing that we already track Third Point's portfolio via 13F filings to begin with.

Loeb clearly doesn't want managers splashing in and out of his investments causing unnecessary tidal wives. What's interesting here is the fact that he is so certain other hedge funds are "piling on" his trades to begin with. While he might be able to discern that by price action alone in some stocks, it's as if he's received confirmation of this from traders, other fund managers, or word of mouth. While many fund managers seemingly talk their book in hopes of convincing other investors to join in on the investment, Loeb has now taken a completely converse approach. A true contrarian, indeed. In an effort to combat herd mentality, he will now only be talking about his positions long after the fact.

We highlight this because it is now the second time we've seen the herd mentality referenced in a prominent hedge fund investor letter. Andreas Halvorsen's Viking Global previously discussed the concentration of hedge funds in particular stocks in response to investor questioning. In this case, investors were essentially worried that many of Viking's holdings were (or had become) hedge fund favorites. The cause for concern was that an increase in concentration could potentially lead to elevated volatility. Halvorsen argued that it doesn't necessarily matter if other hedgies are in the same trades, as long as Viking is proven right in their analysis. On the topic of crowded hedge fund trades, Halvorsen adds,

"There is obviously some risk associated with being in an investment alongside likeminded investors who may have been trained in the stock-picking trade in similar ways in that we may decide to sell at the same time. To limit the consequences of crowded exits, we pay attention to the liquidity of the stocks we trade and take large positions only in the most liquid stocks in the world. The problem of crowding is most acute in our shorts due to the risk of unlimited loss and the potential for canceled borrow arrangements. Here we do tread carefully. As you are aware, we are guarded in disclosing our shorts to anyone and we do on occasion limit the size of our positions, or eliminate them altogether, when we perceive a position to be tight in the borrow market or crowded by equity long-short investors. Ultimately, we live and die by our analysis, portfolio management skills and efforts to contain risk - managing risk is merely another challenge we face in delivering attractive returns at reasonable risk."

So, the approach for dealing with crowded trades and the herd mentality differs between two prominent fund managers. Third Point's Dan Loeb is now attempting to prevent it from occurring in the first place by not discussing new investments until after they've been disclosed publicly via SEC filings. While his approach seems good in theory, the public will still be able to see his investments and "pile on" his investments, albeit on a time-lagged basis. Viking Global's Halvorsen, on the other hand, acknowledges and accepts crowded trades as a component of financial markets. Instead, he seems inclined to tackle it from a portfolio risk management perspective. Given that more prominent funds have sent signals of their stance and voiced their opinion on the topic, we'd expect others to follow suit and chime in as investor concern over the issue rises.

More than anything, this fixation with herd mentality most likely stems from horror stories during the financial crisis when many crowded trades imploded due to various hedge funds that were under duress. These investors were forced to liquidate positions and the severity of declines in certain stocks was only amplified by the fact that high hedge fund concentration led to greater volatility. A perfect example of this is Freeport McMoran (FCX), a metals & mining play that was owned by a plethora of hedge funds. As global economies weakened and hedge funds started their fire-sale, shares of FCX cratered from $123 in June 2008 all the way down to $17 in only six months' time. Peak to trough, the move marked a jaw-dropping 86% decline.

While the above is an extreme example, you can't help but see why some managers would attempt to alleviate or prevent any sort of herd mentality. Indeed, aligning yourself with the hedge fund herd can potentially lead to trampling outcomes. But, there can also be positive outcomes as well. 'Piggybacking', or the notion of following another manager into an investment, can be wildly fruitful if done correctly. As hedge fund replicator Alphaclone has continually demonstrated, investors can easily outperform the market indices and generate hedgie-like returns simply by following the top picks of prominent equity focused managers.

For instance, we just took a look at Alphaclone's top 3 holdings clone of Dan Loeb's Third Point to see what kind of performance could be generated via some simple piggybacking. The portfolio clone rebalances quarterly based on 13F filings and the backtested results are pretty stunning. The 'Third Point Clone' has returned 15.2% annualized since 2000 while the S&P 500 has annualized -0.9% over the same period. This long-only portfolio has a total return of 340.5% compared to the S&P 500's cumulative return of -9.3%. You can take a free 14 day trial to Alphaclone to play around with other funds and strategies as well to see just how successful piggybacking can be.

There is a slight difference between piggybacking and the herd mentality in that there is a cause and effect relationship. In short, piggybacking causes the herd mentality; one is a direct result of the other. The only thing that matters here is the endgame in which certain investment managers all end up owning the same stocks. Yet, just like piggybacking, we see (via backtesting) that you can still garner solid performance by investing in many 'herd mentality' stocks as well.

Alphaclone has also created a Tiger Cub Clone portfolio that simply buys the 10 most popular holdings amongst various hedge funds with past ties to legendary manager Julian Robertson. The long-only version of the Tiger Cub Clone has returned 8.1% annualized since 2000 whereas the S&P 500 has returned -0.9% over the same period. Yet again, we see a perfect example of mimicking prominent investors leading to outperformance.

With piggybacking and the herd mentality comes a bounty of positives, negatives, benefits and risks. It's commendable that Dan Loeb seeks to reduce volatility for his investors by no longer discussing new positions in his investor letters. At the same time though, those investors have a right to know where he is allocating capital and why. Unfortunately for investors, it now seems as though they'll be relegated to scouring over SEC 13F filings just like does on a daily basis. Despite various hedge funds' best efforts to thwart them, piggybacking and the herd mentality are traits that will seemingly never die. After all, they've been laced into Wall Street's DNA for generations.

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