Hedge Fund Pain Brings Loss Worse Than '08 in Crowded Stocks

  • Most hedge fund-owned Russell 3000 stocks down 31% since July
  • Bofa: Hedge funds lead pack in equity selling so far in 2016

It’s well known that stocks with the most hedge funds ownership have been doing badly in the U.S. How badly might surprise you.

While volatility has seeped into every corner of the market over the last year, no group has had it worse than equities where professional speculators are most concentrated. Since July, Russell 3000 Index companies in which hedge funds have the highest ownership percentage have plunged 31 percent, compared with a 2.8 percent decline in the Standard & Poor’s 500 Index, according to data compiled by Bloomberg.

Whether it’s in energy stocks, exchange-traded funds or real estate investment trusts, hedge funds have had their fingerprints all over the swoon in equities that started in August. For individuals, it’s been a lesson in the hazards of investing alongside institutions in a market where daily swings in the S&P 500 have doubled since January.

“When this kind of volatility takes place you become hostage to it, because if those owners decide they want to sell at the same time, it’s not a pretty story,” Marshall Front, chief executive officer and chairman of Front Barnett Associates LLC in Chicago, said by phone. His firm oversees about $800 million. “A lot of hedge funds expected a rising market and when that didn’t happen, it led to a bloodbath.”

Hedge fund clients of Bank of America Corp. have sold a net $3.5 billion in equities so far this year -- more than any other type of investor, according to a research note on March 8. They’re bailing out of a market following a nine-month stretch in 2015 that saw more funds shut down than any time since 2009, according to Hedge Fund Research Inc.

With the benchmark gauge fresh off its second 10 percent correction in less than six months, hedge funds are letting employees go and facing redemptions. That’s forced money managers to free up cash by selling not what they want, but what they can, according to Nicholas Colas, chief market strategist at Convergex Group LLC.

“This is called a risk manager’s sale,” said Colas, who worked as an analyst at Steven A Cohen’s SAC Capital Advisors LP from 1999 to 2001. “It’s not anything fundamentally wrong with the companies. It’s because other people are selling, and it’s getting pummeled and eventually someone taps your shoulder and says ‘You have to sell this.’”

In an industry that prides itself on independent research and its stock-selection acumen, many hedge funds found themselves owning the same stocks in 2015. A lot of them were momentum shares, companies that managed to post larger gains than the rest of the market even as earnings growth among companies flattened.

That’s making the recent rout in equities even worse for a handful of stocks that includes Clovis Oncology Inc., where 34 hedge fund managers owned 42 percent of the company, or Avis Budget Group Inc., in which 49 managers own the same portion, according to data compiled by Bloomberg as of Dec. 31. Each has lost at least 50 percent since their one-year high.

Crowding in those companies means that, should the group of investors decide to sell at once, there are fewer buyers on the way down, according to Stan Altshuller, chief research officer at hedge fund analytics firm Novus Partners Inc.

Losses are even steeper when considering companies with at least 20 different hedge fund investors. An index tracking those most concentrated companies has plunged 45 percent from July 2015 through the end of last month, according to Novus, which follows a universe of almost 1,200 U.S. stocks. That’s a worse relative performance for the group than any equivalent stretch during the 2008 financial crisis, and the worst since at least 2005.

“It’s mind-boggling,” Altshuller said. “Stocks get frantically traded down with spikes in volume. It’s a side effect of forced selling. When you’re deleveraging on a broad level, what you want to do is preserve your position size so you sell off your securities equally. When you have hundreds of managers do that, you feel it in a very violent way.”

While hedge funds were dealt a blow this year by losses in their long positions, they’ve made up for some of it by shorting the market at the highest rate since 2012, according to Goldman Sachs Group Inc. The group has slightly outperformed the S&P 500 so far in 2016 even as their most popular stocks lagged behind, posting a 4 percent loss through Feb. 21, compared with a drop of 6.2 percent in the S&P 500.

One highly publicized meltdown in such a crowded stock was the summer swoon of Valeant Pharmaceuticals International Inc., in which hedge funds comprised 30 percent of the ownership base as of April 2015. The drug-maker suffered a decline of more than 70 percent as investors fled the shares after the company faced short-sellers and pressure in the U.S political arena.

A momentum reversal in January “hurt heavily concentrated hedge fund portfolios, prompting further de-risking and contributing to a vicious cycle that compounded the underperformance of the most popular hedge fund positions,” wrote a Goldman Sachs team led by chief U.S. equity strategist David Kostin in a Feb. 22 report.

In February, hedge funds experienced the worst 10-day period of relative performance since 2011, according to a Morgan Stanley report on March 4. As the market dipped to 1,829.08 on Feb. 11, long/short managers had the biggest short position in stocks since after the financial crisis, the team wrote.

“There’s just too much capital chasing too few ideas, and no liquidity,” said Benjamin Dunn, president of Alpha Theory Advisors, which works with hedge funds overseeing about $6 billion. “The problem is genuinely differentiated managers are getting crushed by deleveraging. It should be a watershed moment for the industry.”

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