Hi-Tech Industry: Making Fast Money

A front page story in today’s Wall Street Journal (“Hedge Funds’ Behavior Magnifies Swings in Market,” January 14, 2011) highlighted the relative performance of so-called “crowded” hedge fund trades versus the broad market. The premise of the article is that hedge fund ownership magnifies the beta of particular stocks and reduces the importance of company fundamentals in determining share performance.

We long ago concluded that money flow is important to the performance of stocks and that it made sense to follow the proverbial “smart money.” We have analyzed more than 7,000 individual stock and ETF positions of roughly 600-800 hedge funds every 90 days for the past decade. Five years ago we started publishing our quarterly Hedge Fund Trend Monitor to track the hedge fund money flow into and out of individual stocks and hedge fund sector tilts on both a long and net basis.

1. Time horizon is vital to understanding how hedge fund ownership data should be incorporated into the portfolio management process. On a daily or even weekly basis, hedge fund positioning is noisy in terms of explaining relative excess return. However, on a quarterly basis the hit rate of outperformance of hedge fund positions is notable.

For example, our basket of stocks with the “most concentrated” hedge fund ownership (Bloomberg ticker: <GSTHHFHI>) has a 71% hit rate of quarterly outperformance versus the S&P 500 since May 2001 with an average quarterly excess return of 296 bp. Our basket of “stocks that matter most” to hedge funds (<GSTHHVIP>) has outperformed the S&P 500 on a quarterly basis 66% of the time since 2001 by an average of 74 bp. [and here we get the all important footnote from Goldman: "Note: The ability to trade these baskets will depend upon market conditions, including liquidity and borrow constraints at the time of the trade." in other words everyone can get in, but when everyone has to get out, nobody will. Enjoy.]

2. Our analysis shows hedge fund holdings generally outperform during equity market rallies and lag during corrections. We recommend investors use our hedge fund holdings baskets to generate alpha during “risk-on” rallies and as a tool for risk reduction during periods of elevated market uncertainty (see Exhibits 1-3).

For example, our “most concentrated” hedge fund basket has outperformed the S&P 500 by an average of 868 bp (745 on median basis) during the six rallies since the market low in March 2009 and underperformed the S&P 500 by an average of 322 bp (385 bp on median basis) during market corrections.

The reverse is also true! Our basket of “least concentrated” hedge fund positions (Bloomberg ticker: <GSTHHFSL>) lagged the S&P 500 during market rallies by average and median of 69 bp but outperformed the broad market by an average of 99 bp (37 bp on median basis) during corrections.

Our hedge fund VIP list (Bloomberg: <GSTHHVIP>) consists of stocks in which fundamentally-driven hedge funds have a large stake. We define stocks that “matter most” to hedge funds as the positions that appear most frequently among the top ten holdings within hedge fund portfolios. For this analysis, we limit our hedge fund universe to funds with 10 to 200 distinct equity positions in an attempt to isolate fundamentally-driven investors from quantitative funds or funds that mirror private equity investments. Hedge funds own between 1% and 38% of the equity cap of the stocks in the basket with an average of 9%, almost twice the 5% average for the S&P 500.

By construction, our VIP list identifies the 50 stocks whose performance will largely influence the long side of many fundamentally driven hedge funds. The VIP basket lagged the S&P 500 by 822 bp during 2008 (-45% vs. -37%). It reversed in 2009, outperforming S&P 500 by 1,391 bp (40% vs. 27%). In 2010, the basket outperformed S&P 500 by 443 bp (19% vs. 15%).

Our VIP basket has a large-cap bias with a median market capitalization of $49 billion compared with $11 billion for the S&P 500. The VIP basket overweights the Information Technology sector (24%) and underweights Industrials (2%). Turnover for the VIP basket since 2001 averages 34% quarterly (52% annually) with 17 stocks typically entering the basket. The next re-balancing will take place after February 15, 2011.

Current constituents of our hedge fund VIP basket scheduled to report 4Q 2010 results next week include the following. Tuesday: C, AAPL, IBM. Wednesday: WFC and USB. Thursday: GOOG and FCX. Friday: SLB and BAC. Exhibit 52 contains the complete list of constituents for all three baskets.

We define “concentration” as the share of market capitalization owned in aggregate by hedge funds. The stocks in the “most concentrated” basket tend to be mid-caps (at the lower end of the S&P 500 capitalization distribution). Hedge funds own between 17% and 48% of the equity cap of the stocks in the basket with an average of 24% vs. 5% for the S&P 500. Stocks with the “most concentrated” hedge fund ownership outperformed the S&P 500 in 2010 by 84 bp (16% vs. 15%).

In contrast, hedge funds own between 0.2% and 0.6% of the equity cap of the stocks in our “least concentrated” hedge fund basket with an average of 0.5% vs. 5% for the S&P 500. The basket outperformed the S&P 500 in 2010 by 255 bp (18% vs. 15%).

Translation: ignore the voice of reason which argues that if everyone else is on the same side of the trade, then you are the guaranteed sucker on the table, and instead follow the Siren song promising untold riches... until such time as there is an actual downtick in the market (better known as the 100 or so shares that make up 50% of market volume) and where no matter how hard you try to get out, you are stuck. For reference: see the first time Goldman butchered the Greeks...

And some pretty charts: ignore the fact that the least concentrated stocks are solidly outperforming their most widely held cousins...

Eric Francis/Getty Images

"Should I stay or should I go? - If you say that you are mine - I'll be here till the end of time - But you gotta let me know - Should I stay or should I go?"

—The Clash, "Should I Stay Or Should I Go?"

Nebraska fans are set for another round of uncertainty, as current LSU coach Les Miles has announced he will meet with administrators at Michigan to discuss becoming the next head Wolverine. Miles, a former Michigan player, has strong ties to his alma mater and many sites are reporting that he is seriously considering making the move.

Should Miles leave Baton Rouge for Ann Arbor, Nebraska coach Bo Pelini will likely be on the short list of candidates to replace him. And a move to LSU certainly has more substance than the rumors of Pelini taking the job in Miami, as was rumored last month. So would Pelini pack up and head back to the bayou?

There would certainly be some incentives to do so. Between Nick Saban and Les Miles, LSU has become a national force in recruiting. Louisiana itself is a hotbed of football talent, and LSU gets first pick of that talent in the way rivaled only by Texas. If Pelini wanted a situation where he could load up quickly, LSU would be attractive.

Pelini would be a familiar face in Baton Rouge, having been the defensive coordinator there from 2005-07 and being part of a national championship team. Pelini would have a familiarity both with the area and the competition in the SEC.

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Monday, January 24, 2011

Making Fast Money

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