Five Major Hedge Fund Themes for Q2 2016

Investors know all too well about the underperformance of the hedge fund industry relative to traditional benchmarks. We won’t talk about that today, but rather look a bit deeper under the hood of the industry to get at the drivers of performance and understand the trends that shape hedge fund portfolios today.

For this article we (exclusively) used public holdings data reported by about 1,200 hedge fund managers that we track in a curated list called the Hedge Fund Universe (HFU). It covers just over $2T in long market value, thousands of securities and hundreds of thousands of positions over roughly two decades of data. Around 85% of the market value is sourced from 13Fs with the rest coming from global regulatory filings. The portfolio is available  for further analysis to Novus clients, like the thousands of managers on the platform (HF’s and long only managers) with a public data subscription.

1. For 2016, Most Losses Concentrated, Wins Diversified

When we ran attribution analysis on the hedge fund industry for YTD 2016, we noticed a large skew towards the detractors. The top detractor, Valeant ($VRX) cost managers more than the top three contributors – Charter ($CHTR), Facebook ($FB), and Restaurant Brands ($RSTRF) combined. While managers chose securities at a rate in line with their historical averages (60% of their stocks were winners and 49% outperformed their sector benchmarks), conviction has not been rewarded. This points not to a failure in performance per se, but a failure in risk management. No one security should be allowed to hurt an active manager’s portfolio so badly.

Historically, active managers make more on their winners than they lose on their detractors by timing and sizing their bets appropriately (captured by the win/loss ratio). This pattern has been broken in recent times by outsized detractors and average-sized contributors.

2. Liquidity Declines to Near-Record Lows

This year is projected to be the first in decades that sees asset outflows in the industry and a shirking of its asset base. But for now, market values controlled by hedge funds are near record highs and liquidity has suffered as a result. There seems to be a floor, however, around 17%, which means hedge funds can liquidate around that much of their portfolios in 30 trading days.

Perhaps even more telling than the asset growth is that the same alpha opportunities seem to be attracting more and more players. Tracking the portfolios of our top 50 non-quant hedge funds, we calculate that the similarity of their portfolios has been on the rise. For example, if you were to pick two top hedge funds at random in 2003, only 4% of their portfolios were expected to be identical – we call that the overlap. Now that number is close to 12%.

But liquidity would have suffered even more if this convergence was not counterbalanced by a secular shift up the market capitalization spectrum, which brings us to trend #3.

3. Managers Move Up the Market Cap Spectrum and Hit Record Highs

While the weighted average market cap for companies in the portfolios of hedge funds is still well below that of the market ($61B vs. $120B for S&P 1500), it is steadily climbing. I have a few thoughts on this. Long term, you want your managers to pick names that are less ubiquitous than Google. But, all the YTD alpha is sourced exclusively from large and mega cap names due to a few large outlier losses in the mid and small buckets, so this isn’t necessarily a bad thing. Second, the HFU is market value-weighted, so it’s skewed heavily toward the largest equity managers. Those managers have experienced a lot of growth and are all but forced to move up the market cap spectrum. Each manager must be analyzed separately to understand if the shift is beneficial to them and their investors.

4. Healthcare Continues to Drag and Managers Reduce Exposure

The two underweight sectors shown above (IT and Healthcare) are in play as managers add to Tech and cut back Healthcare. The negative numbers here show that both sectors are currently underweight relative to the S&P 1500. But alpha has been elusive in most sectors so far this year. While Consumer Discretionary, a longtime HF favorite and overweight sector, has yielded some alpha along with Energy and Materials, it was wiped out by losses of alpha in Healthcare, Industrials and Financials.

5. Most Crowded Stocks Stage a Rebound

Finally, the most crowded securities in hedge funds are making up for some of the losses experienced late last year and in the first quarter of 2016.

Our Crowdedness index, comprised of the 20 most crowded securities of HFU, has outperformed the S&P 500 by roughly 300bps so far this year with March and July accounting for most of the gains.

Take a look at our latest piece below, the Novus Q2 2016 Hedge Fund Ownership Report, to see more aggregate trends & gain transparency into 25 of the largest hedge funds in the industry.

The Q2 2016 Novus Hedge Fund Ownership Report highlights both aggregate industry trends as well as transparency into 25 hedge fund portfolios to help investors and managers understand market sentiment within the hedge fund industry.

This exclusive 56-page report covers aggregate equity ownership across hedge funds and provides detailed coverage of individual hedge fund portfolios that are run by some of the most successful hedge fund managers. Included in the report are the positions, sector allocations and simulated historical performance of these top funds.

Download this exclusive report  now.