Most investors have probably seen the numerous headlines trumpeting the top finding from Goldman Sachs’ most recent “Hedge Fund Trend Monitor.” Hedge fund crowding is now at a record high, and many managers and investors have been riding high on that momentum for much of the year.
However, while all that crowding has been working very well for some, past studies suggest that extreme crowding may mean the time for greed may be long past — replaced by a need for fear.
Hedge fund crowding hits a record high
In their “Hedge Fund Trend Monitor” covering the third quarter, Goldman Sachs analysts reported that the typical hedge fund now holds 70% of its long portfolio in its top 10 positions. That reading matches the second-highest reading for concentration recorded since the firm started tracking it 22 years ago.
The only other time the bank observed higher concentration among hedge funds was in the fourth quarter of 2018. Additionally, the firm reported that the third quarter saw the highest level of crowding among hedge fund long portfolios in the 22 years it has been keeping data on this.
All that crowding has been a key positive for fund managers and the investors who track their holdings. In fact, Goldman’s basket of the most popular hedge fund positions is up 31% year to date, led by the so-called “Magnificent Seven” (Alphabet, AppleAAPL, AmazonAMZN, Meta Platforms, MicrosoftMSFT, NVIDIANVDADIA and TeslaTSLA).
Riding high on the Momentum factor
Unsurprisingly, the combination of high crowding in Big Tech names and Big Tech’s outperformance gave hedge funds a near-record tilt toward the Momentum factor.
In 2022, funds maintained the large positions they had in tech and other growth stocks—even though those stocks underperformed sharply. The result was a record anti-Momentum tilt among hedge funds last year. However, that tilt has reversed and shifted all the way to a near-record tilt toward Momentum as tech stocks recaptured their market leadership throughout the year.
Additionally, the long hedge fund portfolio tilt toward Growth versus value has climbed steadily in recent quarters, reaching the highest level since late 2020.
A warning about crowding
Of course, there are reasons many investors track hedge fund holdings with their portfolio. In fact, the basket of the most popular hedge fund long positions has outperformed in 59% of quarters since 2001, with a quarterly excess return of 43 basis points. However, when crowding soars to record high levels like it did recently, investors should beware.
Researchers have studied what happens when hedge fund crowding soars. While it can be hugely beneficial and gratifying to ride that momentum all the way up, what goes up usually comes down, and when it comes to crowded stocks, the crash tends to be spectacular.
One study conducted by three business school professors and published in 2019 revealed that crowded stocks fall harder than everything else when the next selloff arrives. In their study entitled “Crowded Trades and Tail Risk,” they wrote that “the crowdedness of an equity position is an important ingredient for characterizing risk.”
For example, late 2018 saw the most popular stocks among hedge funds plummet many times more than those with the least hedge-fund ownership. Research into this dynamic has increased in recent years as assets under management by hedge funds have risen almost tenfold over the last two decades.
In their study, the professors did find that crowded stocks tend to do better over time. They discovered that a market-cap-weighted portfolio of the stocks most owned by hedge funds returned an average of almost three percentage points more than those with the least ownership.
In fact, the professors described the advantage of crowdedness as a sort of “quant” factor, equating it to other factors like Momentum. However, they also clarified that stocks with high crowding among hedge funds display significant differences that can’t be explained by existing factors normally based on risk.
The business professors also clarified that with the higher returns also comes increased risk. They found that the most crowded stocks plunge during market selloffs, something observed during the Great Financial Crisis. The professors linked crowdedness with downside tail risk because stocks with significant crowding experienced larger drawdowns during turbulent periods in the market.
Zeroing in specifically on the selloff in October 2018 and citing data from UBS, BNN Bloomberg noted that the stocks with the highest ownership among hedge funds or…
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