Crowded hedge fund trades: Thomson Financial, Bloomberg, Goldman analyze

Date: Friday, December 21, 2007
Author: AllAboutAlpha.com

From AllAboutAlpha.com: Earlier this week, we told you about a recent European Central Bank report containing some research on correlations between hedge funds. Since position-level analysis is very difficult, researchers used the average cross-correlation between hedge funds following similar investment strategies. A high average correlation was interpreted as meaning that hedge funds had likely pursued the same underlying trades.

Position-level data may indeed be next to impossible, but not quite. In the United States, hedge funds are required to file a quarterly form called a “13f” that contains their common shares, convertible preferred shares and convertible bond holdings (long positions only). While the data is somewhat stale (managers have 45 days after quarter-end to submit the report), it provides some interesting insight into so-called “crowded” hedge fund trades.

In a report issued to clients on August 27, 2007, Thomson Financial analyzed the largest US holdings of the top 25 biggest hedge funds in the United States. Collectively, this group managed slightly over US$400 billion. According to Thomson, over 3% of these assets were invested in Sears Holdings (although they acknowledge that most of that may be ESL). The list of 25 also includes names such as Autozone, CVS, Google, Alcoa and RIM.

But does the proportion of the top 30 hedge funds’ investments indicate a trade is “crowded”. Perhaps the number of top 20 hedge funds in the name is a better indication? On this grounds, CVS, Wellpoint, and Qualcomm would be the most crowded.

Examining hedge fund ownership as a percentage of market cap might be a more accurate measure how popular a company is amongst hedgies. Goldman Sachs has created an index it calls “The Most Concentrated Positions” (Bloomberg: GSTHHFHI) is an index of the stocks with the highest percentage of hedge fund ownership (by 700 hedge funds with $936 billion under management in aggregate as of October 1, 2007).

In a November 21 research note, Goldman said that a strategy of buying the top 20 S&P 500 stocks in which hedge funds have the highest percentage ownership has outperformed the index by over 17% on an annualized basis. While they underperform in market pullbacks, they usually rebounded soon after. According the the research note, this was because these names were oversold due to “ownership characteristics” not “fundamental reasons”. (This list includes names like Goodyear, Alcan, and Virgin Media). So score one for the “smart money”, right?

Maybe not. The firm also found that these stocks broke with tradition and didn’t actually rebound after the July/August sell-off. In fact, they continued to underperform the S&P 500 in September. Although Goldman said this strategy “may continue to outperform”, they sent the rocket scientists back to the drawing board.

The result was Goldman’s “Very Important Positions (VIP)” list (Bloomberg: GSTHHVIP)....Full article:

http://allaboutalpha.com/blog/2007/12/20/crowded-hedge-fund-trades-why-the-rules-changed-in-07/