Hedge funds could pay a heavy price for crowding into the same trades.
That is the view of Mike Jemiolo, chief risk officer at Point72 Asset Management, who spoke at the RiskHedge USA conference in New York yesterday (September 20).
"The biggest challenge right now is crowding," he said. "The problem is that for many, many years crowding worked – if you loaded on that factor, you made money. But starting in mid-2015, long crowding stopped working pretty steadily and fairly catastrophically in January and February, and in late 2015 – December or so – short crowding stopped working too."
Investing in crowded stocks can be profitable in the short run as investors coalesce around a common view, but it can also leave funds exposed to market shocks and liquidity demands that are not always explicitly captured in risk models.
The crowding we experienced coming into January this year which unravelled through January and February is a real concern
Mike Jemiolo, Point 72
This was a lesson many hedge funds learned the hard way earlier this year. At the start of 2016, nearly 28% of long equity hedge fund assets were invested in the 100 most crowded stocks. However, these positions were hard-hit by a momentum reversal in January, which triggered a vicious cycle of de-risking that resulted in $100 billion of liquidations across the top 100 stocks owned by hedge funds.
"That's a lot of people running through a very small door," said Jemiolo, adding: "The crowding we experienced coming into January this year which unravelled through January and February is a real concern."
The asset-weighted HFRI Equity Hedge Index lost 4.59% in January and was down a further 1.1% in February.
Despite the heavy losses, the hedge fund industry continues to be dogged by "crowding at multiple levels", Jemiolo said.
Weaning hedge fund managers off crowded trades is a delicate task, however. As crowded trades can be profitable at times, Point72 has stopped short of instructing its portfolio managers to remove them from their portfolios altogether. Instead, the firm seeks to alert its portfolio managers of "particularly dangerous aspects and pockets of crowding", Jemiolo said.
"If a portfolio manager is riding that train – and I'm not saying that he intentionally loads on it because he's a quantitative manager, but rather that his research got him into those names and now they're crowded – I want him to know that and know what's happening when the train starts to leave the tracks."
Those efforts have been aided by a restructuring of the firm's investment teams. Point72 previously had two divisions but has now reorganised into eight groups focused on specific sectors and geographies, with dedicated risk managers and compliance officers for each unit. "As a result, our portfolio managers get three things: enriched management support and guidance, internal collaboration and – most important from my perspective – real-time insights from the risk, compliance and data teams," Jemiolo said.
These changes could help Point72 weather a looming shake-out that Jemiolo believes will derail crowded hedge funds. He sees the disruption playing out in one of two ways. In the first scenario, if the US Federal Reserve starts raising interest rates and winding down its quantitative easing portfolio, "that could be very disruptive to risk assets and cause the industry to flame itself", Jemiolo said. "But personally, I think the shake-out will be a slow grind. I can't predict it will be spectacular, but it certainly will be shaken out."
Point72 is the $11 billion family office of former hedge fund manager Steven Cohen.
The week on Risk.net, December 2–8, 2017Receive this by email