iStock_38050578_XSmallPeriods of high volatility, sharp sell-offs and bear markets create an environment rich in trading and investment opportunities for those that remain level-headed and prepared. As prices recover and the next equity bull market develops, all risk-on trades generally work. Eventually the bull market ages, and finding new trading ideas becomes a bit more challenging.

Developing successful trades in this environment requires creativity and hard work, searching for ideas that are good, yet not so well known as to be crowded, and therefore ineffective. This is easier said than done. Most traders tend to pile into similar mid- and late-cycle trades, which are often marginal with respect to an edge, or tend to be based on economic predictions and/or secular themes rather than exploiting another group of investors.

When too many traders are in the same trade, it becomes crowded. As you might expect, crowded trades lose their edge, and thus should be avoided. That is a good rule to live by, but even the best portfolio managers will occasionally join the crowd due to an extremely high conviction level associated with a trade. An asset class trader must then be aware that the price action associated with the trade will change when there are lots of fellow portfolio managers in the mix.

The concept of crowded trades has become standard trading lingo, much more so than it was 10 to 15 years ago, likely due to the growing popularity of hedge funds over that time period.1,2,3 Yet as far back as the 1960s, crowded shorts were a problem for hedge fund managers.4 In periods of limited opportunities, traders often read similar research reports, are attracted to the same outperforming assets, and in general, lack sufficient imagination to develop a new trade idea. In addition, larger hedge funds tend to implement global macro and asset class level trades due to capacity constraints.

Definition of a Crowded Trade

Whenever there’s too much money or too much attention showered on an asset type, you should expect lower returns, or losses in the case of a trade.

Pundits and fund managers throw around the crowded trade language all the time, often to justify their own positioning. For this blog I use the term “crowded trade” with respect to discretionary trades put on by fellow asset class traders  mutual fund managers, market strategists, tactical asset allocators (at the fund level and investment advisor level) and hedge funds. Basically, these are our competitors in the asset class trading arena.

Table 1 shows an attempt to distinguish the time scale and market participants I’m referring to with respect to crowded trades. Each row consists of different players in the market arena – the asset class traders, quantitative funds, retail investors and institutional investors. The last two columns attempt to distinguish the time scale of various phenomena associated with the crowded trade terminology.

What happens when there’s too much money chasing returns or too much attention to a trade?

Table 1: Classification of phenomenon associated with too much money or too much attention chasing potential returns.

 

Market Player

Timescale:

Weekly/Monthly

Timescale:

Years

Asset Class Traders / Discretionary Hedge Fund Managers and Mutual Fund Managers

Crowded Trades

Most asset class traders do not operate on this time frame.
Mechanical/Quantitative Strategies Understand positioning to potentially predict buying and selling. Too much assets = low returns for everyone
Retail Investors Popularity can potentially lead to panic selling, bubbles and fads. Performance Chasing

Overowned/Underowned

Institutional Investors Institutions generally don’t react at this time scale. Performance Chasing

Overowned/Underowned

Often the “crowded trade” term is used to characterize too much money devoted to a particular trading strategy, like trend-following, currency carry, selling options or using momentum – essentially trading disciplines used by quantitative mutual funds, ETFs and hedge funds. Smart beta ETFs and funds managed by AQR are examples of these sorts of mechanical trading strategies. While these funds may be gamed over the short to intermediate term, the longer-term view for these strategies is that too much assets leads to low returns for everyone, although the time scale for this effect is long and unknown. I wrote a blog last year on this effect.

Crowded trading strategies should definitely be avoided for many reasons. Expected return premiums go down (usually to zero), and correlations to equities go up. Contagion risk increases dramatically, such that correlations can go to one when equities crash. Examples of this phenomenon include the LTCM crises of 1998, the quant fund crash of 2007 and the hedge fund debacle of 2008 to 2009.5,6

I also want to make a distinction that a crowded trade is different than an overowned asset class associated with long-term investors such as pension funds, individual investors, foreign investors, governments, etc. These are long-term asset allocators that are not involved in actively trading asset classes – they usually hire portfolio managers to do that for them. There are ways to exploit these long-term investor groups by front-running their allocation changes and taking the other side of their capitulations. Exploiting performance chasing is one approach, as Table 1 shows.

We often consider what asset classes are overowned and underowned by investors to gauge how strong and long a rally can occur if the asset class begins to move. This is a subject for another blog.

Hopefully these distinctions will become clearer with a few examples. Obviously, if hedge funds in aggregate over-own an asset class by some measure, then we can generally assume the trade is crowded because all hedge fund managers are traders. If pensions funds own “too much equities” when looking at 50 years of historical data, then I would say that pension funds over-own stocks, which doesn’t mean they will suddenly panic out of stocks, or that contagion risk is enhanced.

Long the U.S. Dollar Index (Symbol DXY) is the most recent example of a popular crowded trade (see Figure 1). Practically all asset class traders, hedge funds and tactical asset allocators put this trade on throughout 2014, leading to a strong and relatively smooth upward move. At the beginning of 2015, this trade was crowded by any measure, especially since the trade rationale was so compelling. The United States was the only country with a central bank that planned on raising short-term rates. Most of the rest of the world was in easing mode, led by Japan and Europe, which make up most of the exposure in the U.S. Dollar Index. Rising U.S. short term rates and falling international rates is a great recipe for a strong dollar.

Among investment advisors, currency-hedged international equity ETFs such as DBEU, DXJ and DBEF became very popular. Figure 2 shows the shares outstanding for the Deutsche X-Tracker MSCI EAFE Hedged Equity Fund (Symbol: DBEF). From November 2014 to May 2015, shares outstanding rose by a factor of 10 from about 40 million shares to about 400 million shares.

In addition to the above example, various asset class level trades have been crowded over the past decade. Examples include short Yen in 2013, short dollar from 2005 to 2007, long gold 2010 to 2011, long emerging market equities in 2005 to 2007, peak oil theory in 2007, long emerging market currencies in 2010 to 2012, and short U.S. treasuries off and on over the past 10 years.

Figure 1: Two-year chart of the U.S. Dollar Index (DXY), as of July 20, 2016.

Figure 1 - Dollar

Figure 2: Share count of the Deutsche X-Tracker MSCI EAFE Hedged Equity fund (Symbol: DBEF) in orange along with the U.S. Dollar Index (DXY) in purple. Two-year chart as of July 20, 2016.

Figure 2 - DBEF shares outstanding

Why Do Crowded Trades Fail to Work?

At the most basic level, a crowded trade is overpopulated with arbs, such that any edge has already been milked for all its value. As discussed in a previous blog, having too many arbitrageurs is a requirement for efficient market pricing and the elimination of trading edges.

At times there are stocks (or trades) that have many traders and fund managers with opposing opinions. A burgeoning battle between high-profile hedge fund managers attracts the news media and investor attention, which probably means that prices are near fair value and there’s no edge for anyone. This can also occur when a group of concept stocks attract an enormous amount of trader attention. Another way to illustrate this phenomenon is to ask whether the stock market will go up or down from here, or whether interest rates will go up or down. There are just so many traders asking those questions each day, and so many on each side of those questions, we should rarely expect to have an edge there, and for prices to be near fair value.

A more common crowded trade situation occurs when too many traders are leaning in one direction. This sort of groupthink among fund managers can lead to failure in two ways. First, asset class traders have already pushed prices such that the theme is completely discounted, and thus the trade has no edge going forward. At this point, the release of fundamental news in favor of the trade can often have a disappointing price response. The release of fundamental news counter to the trade will cause a serious and painful adverse price movement.

Secondly, even with a trading edge, the volatility associated with the trade can be greatly enhanced by the presence of many trigger-happy traders ready to exit at the first sign of weakness. The increased likelihood of sharp adverse moves can lead to losses for most traders, even though the trade may ultimately work. In addition, the correlation of the trade with equities increases dramatically, particularly during equity sell-offs, and thus the trade loses much of its diversifying properties.

All of these effects – a reduction in potential return, the enhanced volatility and increased correlation to equities – lead to pain, losses and no trading edge. It’s best just to avoid trades that are crowded and shift to a position of waiting for the next trading opportunity, whether that’s sitting in cash, or benchmark-weighting the portfolio. If you really love the crowded trade, you’ll need to greatly enhance your resolve to avoid being shaken out with all the weaker holders during the many adverse price moves.

Notice that in Figure 1, once the trade was crowded somewhere in the first quarter of 2015, the dollar’s move was essentially done, followed by a frustrating extended trading range.

Detecting Crowded Trades

So how do we determine if a trade is crowded? As with all trading, there’s an art and science to it, and experience dealing with crowded trades will improve skills over time.

Here are the common methods used.

Surveys

There are many surveys of market participant views. Barron’s publishes a popular survey every April and October. The Barron’s survey often asks what the most and least attractive asset classes, equity sectors, currencies, etc., are. I look at this specific survey with great interest. When survey results are heavily skewed to one side, and the investment rationale for the skewing is well known, then I typically view that trade as crowded.

For instance, in the April 25, 2016, issue of the survey, 16% of the participants were bearish on utilities, while only 2% where bullish, suggesting that asset class traders were underweight utilities due to high valuations versus historical data, and the belief that interest rates will eventually move higher. Actually, previous surveys going back to 2010 have been bearish on utilities, yet the utes have kept up with or beat the S&P 500 over the past five to six years.

I looked back at my notes regarding previous Barron’s surveys going back to October 2007, in particular when I noted survey results that seemed to be one-sided in nature as an indication of crowdedness. I then tabulated whether the longs and shorts outperformed and/or made money over the subsequent six months. I also eliminated the surveys of October 2008 and all of 2009 since this was a period of many investment opportunities.

What I found was that over 14 surveys, 47 long trades and 44 short trades, both the longs and shorts were no more accurate than a coin flip. This anecdotal study suggests crowded trades don’t work, but also taking the other side doesn’t work, either. Being a contrarian for the sake of contrarianism cannot be expected to add long-term value – that would be too easy.

Nowadays, the most watched manager survey is the monthly Bank of America Merrill Lynch (BAML) Global Fund Manager Survey. This survey is exclusive and difficult to get ahold of, but the media often publishes parts of it each month. Interestingly, this survey specifically asks what the most crowded trade is.

Keep your eye out for all surveys, and make sure the participants are asset class traders. Others include sentiment surveys, hedge fund ownership figures for individual stocks, and short interest numbers (typically only traders shorting securities).

There are often pension/institutional money manager surveys, but these folks tend to manage very diversified portfolios with few intermediate-term bets on a particular asset class. These surveys are very interesting to game fund flows associated with their asset allocation moves, but not to gauge crowded trades.

Financial Press

Any time the financial press starts reporting the merits of a particular trade, or profiling a manager who’s been successful with the trade so far, then it’s most likely crowded. Everyone reading the Wall Street Journal, Barron’s, or the Financial Times likes these sorts of articles, so editors will oblige. The more articles about a trade, the more likely it’s crowded. It’s much better to implement a trade that no one is talking about.

Price Action

Is the character of the price action changing? Are there more and sharper adverse price moves? Are correlations changing? Are sharp downturns correlated with equity downturns? Observing these changes, often after a large upward price move, can provide clues that many fellow traders have joined the trade. You can also watch daily hedge fund indices and how they are correlated with daily equity, bond, commodity and currency moves.7-10 The long dollar trade shown in Figure 1 became so crowded that the dollar’s correlation to equities switched from a historically negative correlation to a positive correlation.

Another clue of a crowded trade is to watch the price action around bullish or bearish news. If the trade has a lackluster response to news that should be highly positive, then the market has obviously priced in the move, and the trade is probably crowded. This behavior is an illustration of the classic “buy the rumor, sell the news” trading adage.

 

Summary

I love it when my portfolio consists of trades and investments that are completely ignored by the press and the price action is positive and nicely uncorrelated with equities. But this doesn’t happen very often, so we need to account for crowded trades. The best approach is to avoid crowded trades, which is especially important with all the hedge funds active in the markets these days. There is no edge in crowded trades. I’d much prefer an uncrowded trade with a lower return potential than a crowded trade with higher return potential.

If you suspect that a trade is crowded, then it’s time to reassess the reasons for being in the trade. Have prices totally discounted the theme associated with the trade? A trade based on fund flows can still work even if the trade is crowded with asset class traders. A trade based on a secular economic theme such as peak oil, demographic trends, and growth stories are typically weak trading edges at best.

If you decide to hang on to a crowded trade because of a high conviction level, then you need to mentally prepare to be tested by the market. Perhaps you can even exploit the crowdedness of the trade by taking the other side of the sharp reversals as a motivated selling opportunity. Taking the other side of the motivated buying associated with a short squeeze is another example of a way to take advantage of a crowded trade.

Ultimately, part of improving skills as an asset class trader is to constantly rework the trade idea search process to improve creativity, identify and explore less crowded areas, and be quicker to enter a trade to allow for sufficient profit before exiting the trade when many other traders join the party. See this recent interesting article on finding uncrowded ideas.


References

  1. Strasburg, J. and Pulliam, S., “Pack Mentality Grips Hedge Funds”, Wall Street Journal, January 14, 2011.
  2. Herbst-Bayliss, S. , “Hedge funds that crowded into same names likely to nurse losses”, Reuters, August 28, 2015.
  3. Childs, M., “How the herd mentality hurts hedge funds”, Bloomberg, March 17, 2016.
  4. Academic articles on crowding.
  5. Loomis, C.J., “Hard Times Come to the Hedge Funds”, Fortune, January 1970.
  6. Lowenstein, R., When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2000.
  7. Khandani, A.E., and Lo, A.W., “What Happened to the Quants in August 2007?”, Working Paper, September 20, 2007.
  8. Pojarliev, M. and Levich, R.M., “Detecting Crowded Trades in Currency Funds”, Working Paper 15698, January 2010.
  9. Yan, P., “Crowded Trades, Short Covering, and Momentum Crashes”, Working Paper, November 1, 2013.
  10. Blerina, B.Z., Sias, R., and Turtle, H.J., “Hedge Fund Crowds and Mispricing”, Working Paper, December 8, 2014.

Disclosure

The content contained within this blog reflects the personal views and opinions of Dennis Tilley, and not necessarily those of Merriman Wealth Management, LLC. This website is for educational and/or entertainment purposes only. Use this information at your own risk, and the content should not be considered legal, tax or investment advice. The views contained in this blog may change at any time without notice, and may be inappropriate for an individual’s investment portfolio. There is no guarantee that securities and/or the techniques mentioned in this blog will make money or enhance risk-adjusted returns. The information contained in this blog may use views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date of each blog entry. The content provided within this blog is the property of Dennis Tilley & Merriman Wealth Management, LLC (“Merriman”). For more details, see the Important Disclosure.

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