Hedge Fund Liquidity Falls to Danger Zone in U.S. Stock Market

  • Herd mentality leads to stock crowdness, simultaneous selling
  • Similar conditions have preceded big selloffs in the past

There’s safety in numbers. Until a stampede starts.

That’s the theory underlying a study of hedge fund holdings by Novus Partners Inc., which sought to calculate how easily the market could absorb concerted selling by large money managers. Using an analysis that turns mainly on how much volume is occurring in stocks favored by professional speculators, Novus says liquidity is at an all-time low.

“Their ability to sell in the marketplace is really going to depend on their peers who are trying to sell at the same time,” Stan Altshuller, chief research officer at the analytics firm, said by phone. “It becomes the prisoner’s dilemma.”

Novus began with the premise that most hedge fund managers have an idea of how a stock would react if they alone started bailing. It then tried to estimate a broader impact: what if everyone bailed at the same time? To do this it devised a hypothetical portfolio representing all hedge fund holdings and tried to quantify how much could be sold in 30 days.

Looking at equity funds with $2 trillion and limiting daily divestitures to 20 percent of a stock’s average volume, Novus calculated that the market could absorb only about 13 percent of the industry’s total holdings in a month right now. The measure, dubbed 30-day liquidity, has averaged 32 percent since it began tracking the data in 1999.

In a market where volatility has all but disappeared and the S&P 500 Index trades at all-time highs, the study suggests a hidden risk lurks should sentiment suddenly sour. A similar deficit of liquidity exacerbated selloffs in the past 18 months as stocks beloved by hedge fund managers led the plunge.

Low liquidity itself isn’t a catalyst for turbulence -- just look at the current state of the VIX. But difficulty disposing of stocks can add to market stress. Take the rout that greeted investors this time last year. On Jan. 13, 2016, the 20 stocks in the S&P 500 with the most hedge fund ownership tumbled an average of 4.4 percent, almost double the decline in the benchmark, data compiled by Bloomberg show. Among the 10 most-owned, losses averaged 5.6 percent.

Hedge fund liquidity as calculated by Novus is only tangentially related to broader market volume, and indeed, overall stock trading has risen in the past three years. The main reason it could be harder for managers to get rid of stocks is because they’re chasing the same companies.

Such congestion, or “crowdedness,” has worsened recently as investors rode the reflation trade, scooping up banks and cyclical shares on optimism that President Donald Trump’s pro-growth policies will stimulate economic growth. A measure of hedge fund crowdedness according to Novus has also risen to the highest level on record.

As money flocks to popular names, the window of escape gets smaller. Novus, which sells products aimed at avoiding liquidity traps and managing risks, theorizes that it’s no coincidence that in each of the last three years, the low point of liquidity all came within three months of a market selloff. Last time it was as low as it is now in July 2015, the S&P 500 suffered the worst decline in four years the next month.

In addition, the last bear market started in October 2007, just four months after liquidity appeared to be drained out from hedge funds.

“When hedge funds get spooked about something and they all delever, there are going to be small pockets that get disproportionately hurt,” Altshuller said. “Certain stocks are down 20, 40 percent with no apparent reason. Others catch the fear bug and start selling.”

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