Tiburon Capital Management has posted a paper about crowded trades and the resulting ‘avoid’ lists: that is, about those bright alpha-pursuant ideas that everybody else has figured out already, and that accordingly are bound to underperform.
The paper (in its first footnote) tells an oft-told joke. It’ll be told again here, since classics bear repetition. An efficient-markets economist and his student are walking down the street. The student points out a $1 bill lying on the sidewalk. The professor tells him it would be a waste of effort bending over to pick it up, since “if it were real it wouldn’t be there.”
The paper also gives what one presumes is the official Tiburon response to the efficient capital markets hypothesis: that sometimes the bill that looks like a $1 bill is actually a $5 bill, and whoever (actively) figures that out first and actively bends over to pick it up, wins a well-deserved profit.
The most crowded long trades
But that isn’t really the issue with which the paper as a whole deals. Rather, it is concerned with what happens when lots of people, or lots of hedge funds, spot the same bill lying on the same sidewalk at once. They bump skulls all trying to bend down there, and whoever gets it will perhaps have expended costs in the scrum that will exceed the value of what has been won.
The UBS prime brokerage unit offers a list of the top 25 most crowded U.S. manager longs and shorts. On the long side, tech companies are well represented on the crowded list. Hedge funds are crowding into Alphabet (the company that used to be known as Google), for example. Indeed, Alphabet is represented twice in the top five crowded long trades: both class A (NASDAQ:GOOGL) and class C (NASDAQ:GOOG). Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), Activision Blizzard (NASDAQ:ATVI), and Intel (NASDAQ:INTC) are all also represented in the top 25 most hedge-fund-crowded long trades.
As if to make the point that “hi-tech” is not always the hardware/software sort of thing, though, this most crowded list also includes the biopharm sort of tech stock: specifically Gilead Sciences (NASDAQ:GILD) and Pfizer (NYSE:PFE).
The most crowded short trades
The most crowded short trades, again according to UBS as per Tiburon’s discussion, are trades that reflect pessimism about the broader markets. Thus, number 1 on the list is the SPDR S&P 500 ETF (NYSE:SPY) Trust. The list also includes old-tech stalwarts such as General Motors (NYSE:GM), Ford (NYSE:F), and Alcoa (NYSE:AA). It includes also a couple of prominent brick and mortar retailers-to-the-masses whom everyone wants to short: Target (NYSE:TGT) and Kroger (NYSE:KR).
Let’s look at those two for a moment. Target was the victim of a widely-publicized hack last year. Some analysts concluded that both its vulnerability to the attack and its bumbling in the aftermath were bad augurs for its stock price. Any play based on that, though, is long since spent. TGT was trading in the neighborhood of $80 to $84 in the middle of 2015. It slid through the course of that year and the start of this year saw it get as low as $68, but it has since rebounded, and in late February it shot back up above $80, the old neighborhood, on the strength of numbers indicating (as Maher Syed wrote for Zachs), that it “is gaining traction in the e-commerce space.”
Kroger became an object of interest for short sellers when its stock value hit 22 times earnings last spring, and in the face of stepped-up competition in the discount grocery space from Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST).
But such jitters notwithstanding, 2015 was an “up” year for KR, from $32 to $42, or an increase of 30 percent. The stock price began 2016 with a lot of volatility, but it seems to have settled down around $38.
The Point
But the point of Tiburon’s discussion of crowded trades is risk management. Buyers and sellers should ask themselves, “How are your odds changed by how crowded the trade is?”
The final footnote in the paper praises the Kelly formula as something that should always be considered in sizing positions. The simple prose version of that is: don’t bet in unfavorable games. Limit the amount of your bet even in favorable games.