HEDGE FUNDS AND MUTUAL FUNDS CONVERGE ON U.S. STOCK HOLDINGS / THE FINANCIAL TIMES

Hedge funds and mutual funds converge on US stock holdings

Ownership overlap increases risk of crowded trades, which can lead to large losses

Chris Flood


NYSE-listed Chipotle is just one US company where both hedge funds and mutual funds have large overweight positions © REUTERS


The overlap in US companies owned by both hedge funds and traditional mutual funds has climbed to a fresh high in a convergence that elevates the risk of crowded trades.

About 12 per cent of the top 50 US stocks held as overweight positions by hedge funds and traditional mutual funds are owned by both sets of managers, according to Bank of America Merrill Lynch. The overlap in ownership was zero as recently as June 2015.

Savita Subramanian, head of US equity and quantitative strategy at BofA, said strong momentum effects in the US market were one possible explanation.

US stocks that have performed well have tended to attract more buyers, helping the shares of those companies to maintain their upward momentum.

“We have seen convergence of strategies that has led to a narrower and narrower cohort of stocks outperforming the market,” said Ms Subramanian.

This has also been reflected in valuations where the gap between expensive and cheap stocks, measured on a share price multiple to earnings, stands close to an all-time high.

“Valuations for growth stocks have been creeping higher while the reverse is true for value stocks. Being a value focused investor has been the best way to lose money in recent years,” said Ms Subramanian.




Companies owned by both sets of managers which are also held as large overweight positions by hedge funds include United Airlines, Charter Communications, health insurer Humana, Las Vegas-based hotels group Wynn Resorts, aircraft components manufacturer TransDigm and restaurant chain Chipotle Mexican Grill.

The tech stocks known as the Faangs (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) have also been popular choices for hedge funds and mutual fund managers.

“Hedge funds like to focus on sectors where there is high volatility, such as the large US technology stocks which are widely held by mutual fund managers,” said Sara Rejal, a senior director at Willis Towers Watson, the adviser.

Ms Rejal added that more hedge funds were now running “long only” strategies, which may have increased their overlap with mutual funds. “Some hedge funds have become overly conservative because their clients don’t want large drawdowns but this has led to even worse performance and reduced their ability to generate returns,” she said.

If a hedge fund has already banked profits on successful trades, it can then choose to shrink the tracking error relative to the US market as a deliberate tactic.

“In that scenario, hedge funds tend to pad out their portfolios with the largest market capitalisation stocks, such as the Faangs, which will lead to more overlap with the holdings of mutual fund managers,” said Farouk Jivraj, head of quantitative investment strategies research at Barclays.

But overlapping holdings between hedge funds and mutual funds create the risk of crowded trades, which can lead to larger losses if a company misses an earning targets or issues a profit warning, and investors rush for the exit.

“The risk of crowding is high if the overweight position is held in a company with a smaller market value which has less liquidity. The risk is not as great if the overweight is in the biggest, most liquid stocks,” said Mr Jivraj.