Crowded Trades & Unconventional Behavior

Investors in the average hedge fund would have been better off putting their money in Vanguard index funds. The performance of the prophets of profit is consistent only in its disappointment.
 
Two of the biggest drivers of this lackluster performance seem obvious: high fees and short positions that lose money as the market goes up.
 
But we believe that a third problem is more intriguing and systemic. Hedge fund managers have a tendency to herd into the same positions. Many funds have holdings that look an awful lot like the index, with huge positions in large-cap U.S. stocks such as Apple, Alphabet, Facebook, etc. Thus far, these bets may have been relatively safe and profitable. But herding may also end disastrously, both for the hedge funds and the target companies (consider the well-known collapses of Valeant and SunEdison, and the pain for the hedge funds involved).
 
The economist Jeremy Stein calls this the “crowded trade” problem. His theory suggests that in “crowded trades,” it can be difficult to know whether a stock’s price increase reflects underlying fundamentals, or other investors piling into the stock. The performance of these crowded trades thus may become unmoored from the fundamentals of the bet and closely correlated with the fund flows and borrowing ability of the investor funds.
 
We believe that investors who hope to achieve real outperformance of the market should avoid this herd mentality and look for managers with unconventional strategies. An influential study suggests that one of the best predictors of fund performance is the difference between the fund's holdings and that of the benchmark: the bigger the difference, the better the performance. This difference is known as a fund’s “active share.”
 
The logic here is simple: In the words of Oaktree Capital Management’s Howard Marks: “You can’t take the same actions as everyone else and expect to outperform.”  Consider this simple table from Marks.
 
Figure 1: Behavior vs. Outcomes

Source: Howard Marks, “Dare to be Great,” 2006
 
The problem is often that the more unconventional an idea, the smaller the amount of money that can be deployed. This may be the reason that smaller mutual funds and hedge funds have historically outperformed their larger counterparts. They seem to be better able to enact insightful, alpha-generating strategies on a reasonable scale. The graph below shows the negative relationship between hedge fund returns and fund size.
 
Figure 2: Fund Returns vs. Fund Size

Source: Getmansky, 2012
 
Unconventional strategies are small by definition — if large, they would, by necessity, begin to look like the index. Stanford professor Charles Lee often says that to win in active management you either have to be sheltered from the wind or predict which way the wind is blowing.
 
Vanguard is the great ocean freighter, offering the lowest cost possible on every non-capacity constrained strategy. The only way to win as an active manager, then, is to be a speedboat, deftly exploiting small opportunities that Vanguard can’t or won’t. The future of active management is with the niche, the unconventional, and the capacity constrained: for everything else, there’s an index fund.