Hedge funds are at risk of a particularly painful experience in the event the market suddenly rolls over in the face of mounting risks to the outlook and rising fears of a recession in the US.
That’s one takeaway from the latest edition of Goldman’s hedge fund trend monitor, which shows that the average fund holds 69% of its long portfolio in its top 10 positions.
The figure was 57% a decade and a half ago.
Meanwhile, turnover continues to grind ever lower, with just over a quarter of positions churned in the second quarter, a figure which Goldman notes usually clocked in at between 35% and 40% on a quarterly basis throughout the last cycle (see the visual in the right pane above). As you can see, the largest positions barely turn over at all.
The combination of holding fewer, more concentrated positions and just sitting on them (to speak colloquially) leads to crowding and that, in turn, helps explain the outperformance of momentum.
It shouldn’t surprise anyone that crowding is correlated to momentum and that spikes in the former and outperformance in the latter accompany periods of economic angst. If you look at what stocks “matter most” (i.e., the names that comprise Goldman’s hedge fund VIP list), it’s just a who’s who of growth stocks. “Our hedge fund crowding index shows a general trend of rising crowding this cycle, with particular spikes during periods of economic stress”, Goldman writes, adding that “a the same time, our long/short Momentum factor has outperformed sharply, a dynamic also characteristic of markets concerned with economic growth”.
The problem, of course, is that this crowding and high concentration leaves folks vulnerable to a rout, something we saw in October of 2018, when the Long/Short crowd got caught in a vicious October drawdown for tech. By the time the calendar flipped, the Nasdaq 100 had suffered its worst quarter since the crisis.
Goldman warns of the potential for lackluster liquidity to exacerbate any potential unwind. “The recent increase in hedge fund concentration and leverage make funds particularly vulnerable to a potential market unwind, particularly if accompanied by the decline in liquidity that typically coincides with falling risk appetite”, the bank warns.
This is potentially more precarious right now considering the VIP basket trades at a 13% forward P/E premium to the S&P. Historically, higher valuations have presaged lower excess returns.
The bottom line is that the more worried everyone gets about a recession, the higher the risk associated with crowded positioning. In yet another example of a self-feeding dynamic, Goldman notes that the beta of the VIP basket to the S&P tends to be larger during selloffs than during rallies.
Still, everything should be fine as long as nobody yells “fire!”. Or “recession”. Or “antitrust investigation”.