There's a mesmerizing video making the rounds on Facebook of a guy who takes a trombone out into an empty cow pasture, sits down in a lawn chair and plays the song "Royals" by the New Zealand singer Lorde.
Before he even gets to the first chorus, cows begin hustling over the hill toward the sound of the music. By the end of the video, he has a whole herd crowded together in front of him and they all wag their tales and moo their approval for the trombonist.
What on Earth, you may ask, does this Facebook video have to do with the stock market? Great question, thanks for asking! Returns have been a lot like these cows -- individual stocks over the last few years have appeared to be moving together like a herd of cows mesmerized by the same trombonist. Market pundits have lamented this lack of return dispersion again and again and tried to wish it away, without much success.
It's hard to know -- without access to a herd of cattle, a trombone and a lot of free time -- whether it's the specific song or the moo-like sound of the instrument itself that has enthralled the cattle. Similarly, it's not 100 percent obvious what's caused the herding in the stock market -- maybe it's the sweet music of low interest rates played by the Federal Reserve that has caused fixed-income cows to march into the stocks pasture, or maybe it's the growth in popularity of index funds that makes the whole market look like a field of grass rather than a buffet table covered with an assortment of treats.
Yet, there's an interesting surprise lurking amid all this herding in returns: dispersion among performance of equity hedge funds is actually increasing. The spread between the top fourth and bottom fourth of long-short strategy returns in the Credit Suisse Hedge Fund Index has widened from 10 percent to as high as 20 percent over the last year. That type of contrast is usually only seen during very volatile periods, not the calm markets we've seen this year, according to Mark Connors, Credit Suisse's global head of risk advisory.
How could the stock market be herding together so closely, while the cattle of the hedge fund world are scattered all over the pasture? Connors cited structural shifts in the market for the first part -- increased regulations such as Basel III banking rules and protracted central-bank accommodation have reduced liquidity and equity volatility while increasing correlations within and across asset classes, he wrote in a note this week.
"These elements along with others have conspired to compress the opportunity set and blunt many of the traditional tools employed by hedge fund managers," he wrote. "The landscape is not entirely bleak as managers are evolving their processes to adapt to these challenges, attracting investors who remain interested in the actively managed space."
The low dispersion of returns is unlikely to end soon, according to Goldman Sachs Group Inc.'s Amanda Sneider and colleagues, whose recent report sheds some light on what stocks hedge funds are chasing. The Goldman team advises being overweight technology stocks because the group offers the best chance for higher return dispersion among industries, not to mention strong earnings growth and relatively low valuations.
And to close the loop with that video on Facebook, their analysis shows that the social network with over a billion users (and at least one excellent cow video) is one of the most popular hedge-fund holdings among tech stocks...
...even though hedge funds continue to underweight the group, meaning they hold less in technology shares overall than what is represented in benchmark indexes.
Mutual funds are also underweight technology stocks, according to the Goldman report. A big part of this is because of Apple Inc. The funds in Goldman's analysis have about 2.9 percent of their portfolios in Apple, compared with the stock's weighting of almost 4 percent in the S&P 500 and 3.3 percent in the Russell 3000 Index. It's hard to know why stock pickers are in aggregate snubbing Apple, a company with higher-than-average growth estimates and lower-than-average valuations. Maybe as a group they're skeptical the growth can last, or maybe there are many who are wary of the risk that comes with any single stock making up too much of a portfolio.
One thing is clear: managers continue to love consumer companies that rely on discretionary spending. Mutual funds are overweight the group by more than one full percentage point and hedge funds are overweight it by more than seven percentage points, according to Goldman. Consumer discretionary overtook technology as the largest holdings in hedge funds in 2012, and it's been that way ever since.
How long will that preference last? Maybe 'till the cows come home.