Hedge Funds' Laziness Warns of Coming Problems

There is no area of finance that is more misunderstood than the hedge fund industry.

Hedge funds have gotten a bad rap and it’s easy to see why. Part of the reason for this is that you can find 10 negative articles for every 1 positive article. Part of the reason is that hedge funds are secretive and opaque by nature and so the lack of transparency lends itself to misinformation.

Oh, and events like Bernie Madoff don’t help either.

I’m not here to defend the hedge fund industry, quite the contrary. When I saw the latest data on the top 50 hedge funds, I couldn’t believe what I was seeing and I asked myself, “These guys get paid a 2% management fee and 20% profits to manage money like this?!”

But remember, the hedge fund industry is a mere infant compared to the mutual fund industry. According to Factset.com, as of the end of the first quarter, hedge fund assets hit a new all-time high of $2.7 trillion. The mutual fund industry has approximately $26 trillion in assets under management.

I was surprised by the data and I think you will be too.

Anyway, the top 50 firms control approximately $700B in assets or approximately 25% of the total hedge fund industry. The top 50 holdings represent about $200B of the $700B in total assets or approximately 30% of the asset managed by the top 50 firms are invested in these top 50 stocks.

Big 50 Not Diverse

The geographical allocation of these top 50 holdings is: 86% Unites States, 3% United Kingdom, 2% Canada, 1% Japan, 1% China, the remaining 7% is other countries with insignificant individual weightings.

Frankly, I was shocked by this allocation. I’m generally under the impression that the smartest people in a particular industry tend to migrate to where the compensation for their particular strengths is the highest. I also tend to think that the top 50 firms essentially have unlimited resources and access to unlimited intellectual capital.

That said, I couldn’t believe that the largest guys in the game have 86% of their equity exposure based in the US with the second largest allocation being a mere 3%.

Drilling down to the market cap level, there isn’t a lot of creativity here either. 65% of the equity allocation resides in large companies with market caps greater than $10B.

The upside of this is that the top firms only have 6% of their equity allocation in small caps or companies with market caps under $2B. US small caps have historically performed very poorly during periods of slowing economic growth.

Big 50 Sectors

Drilling down yet another level, let’s look at the sector breakdown of the top 50 holdings. The largest three allocations from a sector perspective totaling 52% of the equity allocations are: consumer discretionary, technology, and financials.

Huh?

Yep, the largest 50 firms with unlimited resources for research and intellectual capital have invested half of their equity assets in the three sectors that perform the worst when US economic growth is slowing, which is what is occurring right now.

How does this happen?

Look at the sector breakdown of the big 50 firms versus the sector breakdown of the S&P 500, the allocations are nearly identical.

There are two sectors where there is greater than a 2% deviation from the S&P’s allocation to a particular sector: consumer discretionary and consumer staples.

What’s more, hedge funds have allocated 8% more capital towards consumer discretionary than the S&P’s allocation to that sector.  Consumer discretionary is the largest sector weighting for the top hedge funds and there isn’t a worse sector to be exposed to when US growth is slowing.

Case in point, so far this year, the consumer discretionary sector (XLY) is down 0.52% versus a return for the S&P 500 (SPY) of 1.18%.

Top 3 of the Big 50

Now let’s take a look at the last level, the individual stocks themselves. The top 3 stocks held by the largest firms based on dollars invested are: Apple (AAPL), Microsoft (MSFT) and Google (GOOG). The top firms have allocated approximately 17% of their equity allocation to the technology sector and these three companies are a decent chunk of that allocation.

This matters for 3 reasons.

One, if growth in the US continues to slow, technology will be one of the worst performing sectors.

Two, so far this year, the US technology sector is up just 8 basis points, so the shift away from this sector has yet to occur.

Three, the top 3 holdings in XLK, which consists of approximately 30% of the entire exchange-traded fund: Apple, Microsoft and Google.

The point being that once the rest of the world sees what we’ve already been discussing since mid-January, watch out!

Those three stocks are held by over 20 of the top 50 hedge fund firms. In a similar fashion, the top firms have allocated 18% of their equity assets to the consumer discretionary sector. Not shocking that a number of the top holdings in the consumer discretionary ETF, XLY, are represented in the top 50 stock holdings of the largest firms.

And despite the fact that XLY is the worst performing US equity sector so far in 2016, the rotation away from XLY has yet to occur. If and when those firms decide to reduce their exposure to these companies because economic growth is slowing, XLK and XLY, among others, are going to feel it.

The time to get out of your XLK (technology stocks)  or XLY (consumer discretionary stocks) holdings - or to go short certain sectors if that’s your thing - is not once the stampede for the door has begun, but prior to it.

Hedge fund managers are routinely trotted out on CNBC and Bloomberg and pitched to viewers as the smartest guys in the game.

Some things are not always as they seem.

I track a number of proprietary indices that cover a wide range of markets and investor types. 2 of those indices are geared towards understanding how hedge funds are allocating capital and how they are performing.

One of those indices is an index of the most owned stocks by hedge funds, which is down 7.8% year to date. On the other hand, I track an index of the least owned stocks and so far this year, too; it’s up 5.0%.

The stocks that the smartest guys in the room hate the most have outperformed the stocks they like the best by a whopping 1300 basis points! The lesson here is that just because an investment manager’s strategy is cloaked in a hedge fund doesn’t automatically mean it’s a lock for superior returns. Buyer beware.