While hedge funds are retreating from a record-setting equity rally, their faith in their own stock-picking skills is growing stronger than ever.
The boldness is on display in data compiled by Morgan Stanley’s prime broker unit. The firm’s hedge-fund clients have boosted holdings in their conviction buys, with the 50 most-crowded stocks making up more than 40% of the long book last month for the time since at least 2010.
The data speaks to growing confidence among managers after six months in which retail investors repeatedly stole their thunder. Indeed, the industry’s performance on generating above-market returns, or alpha, just got a boost, with bearish wagers scoring the best month on record for funds tracked by Morgan Stanley.
But anyone who witnessed crowded stocks bearing the brunt of selling from time to time may take it as a sign of trouble brewing. That is, with hedge funds relying so much on the same stocks, when they pull out, the decline can be amplified.
“When we buy something, we want to know who we’re now owning it with because it’s a potential risk, both to the upside and downside,” said Mark Freeman, chief investment officer at Socorro Asset Management LP. “No one complains about the up part of volatility. But if a group becomes concerned and everybody rushes to the exit, it puts pressure on liquidity itself, which then exacerbates the downside move in stocks.”
The damage from quick unwinding was exemplified earlier this year, when shares with heavy hedge-fund ownership dropped twice much as those with the lowest ownership during a selloff that wiped out almost $1 trillion in the value of Nasdaq 100 companies.
So what kind of stocks have hedge funds piled into? Software makers. Their net exposure according to Morgan Stanley has climbed to a record.
Stock crowding has become a frequent topic of discussion among Wall Street handicappers. Bank of America strategists led by Savita Subramanian, for instance, publish a research report titled “What Are Your Neighbors Doing?” on a regular basis. In the note released Tuesday, the team said several of the largest stay-at-home beneficiaries including Amazon.com Inc. are more crowded among active funds from a year ago despite an economic reopening.