Hedge Fund Concentration

06/08/2016 10:00 am EST


Landon Whaley

Editor, Gravitational Edge

Landon Whaley has conducted a fascinating study of hedge funds, looking at their high concentration in select sectors, geographic markets and even individual stocks. The editor of The Whaley Report explains why this concentration should be a concern to investors.

Steve Halpern:  Our guest today is Landon Whaley, market timer and ETF specialist and an editor of The Whaley Report.  

Landon Whaley:  Steven, I’m doing really well.  Thank you for having me.

Steve Halpern:  Now you recently conducted a fascinating review of the hedge fund industry and found some surprising information, particularly the high concentration among a relatively limited universe of investments.  Could you expand on this?

Landon Whaley:  Absolutely.  Even though the hedge fund industry is just one-tenth the size of a mutual fund industry, it tends to attract a lot of the top talent because the compensation structure of the hedge funds are so much more lucrative in that as normal mutual funds.  

I generally work off the premise that the largest hedge funds have essentially unlimited resources and access to unlimited intellectual capital.  In layman terms, that means they’ve got tons of money and access to the very best and brightest from around the world.  

With that as the backdrop, when I saw the latest holdings information for the top 50 hedge funds, I couldn’t believe what’s I was seeing.  It’s important to remember the top 50 hedge funds control about $700 billion dollars in assets, which is 25% of the total industry.  

There are 5000 hedge funds in the world, which mean the top 1% control a quarter of all the industry assets.  Here’s the kicker though, approximate one-third of those assets are in just 50 stocks.  

If you consider there are tens of thousands of stocks traded on exchanges all over the world, and yet the smartest guys in the room are all piling into the same 50 stocks.  

As I believe we’ll get into later, it’s not just a small number of stocks that’s astonishing, it’s the geographic and sector concentration of those companies that makes me question what exactly these hedge fund funds are doing with their unlimited resources.  

Steve Halpern:  Okay, so let’s look at some of those points, and as you eluded to this high concentration from a geographic perspective.  Could you explain this?

Landon Whaley:  That’s exactly right.  I mean, not only are they all piled into the same 50 stocks, but the majority of those stocks trade right here in the US.  

Of those top 50 holdings, 86% are companies form the United States, 3% are from the UK, 2% from Canada.  Japan and China are represented by about 1%.  I’m shocked.  I mean, it’s a great big world out there.  

I find it hard to believe that all of the very best opportunities are here in the US, and it’s not that these guys don’t have any emerging marketing exposure.  They don’t have any exposure to another developed nation to speak of.  

I mean, is the US really that much better off right now that it deserves 90% of the capital they’re willing to dedicate to equities.  Not from my perspective.  The largest and supposedly smartest guys in the investment game are all piled into the same 50 stocks, 90% of which are U.S. companies.  

It’s just disappointing how unoriginal they are, and it’s no wonder that institutions like the California Employees Retirement System are yanking money from these guys left and right, and that their fees that they’ve been charging for years are getting squeezed from every angle.  

Steve Halpern:  Now when you look at the holdings of these firms, you also noticed that they’re concentrated in very, very few sectors, in fact, you highlight they’re focused on three factors that also share in the characteristic of performing the worst when US economic growth slows.  Can you tell us about these sectors and what that suggests to you in terms of their investment posture?

Landon Whaley:   Sure, again, if we drill down, we see that the largest three allocations from a sector perspective are to consumer discretionary, technology, and financially.  

I mean, these guys have unlimited resources for research and yet they piled the majority of their money into the three sectors that tend to perform the worst when US economic growth is slowing.  

I bring this up because U.S. growth has been slowing for five consecutive quarters.  Even year-to-date, these are three of the worst performing sectors.  Only healthcare is performing worse.  

If we take it a step further and look at the sector breakdown of these firms versus the sector breakdown of the S&P 500, the allocations are nearly identical.  The only difference is that hedge funds are overweight these three sectors.  

The largest hedge funds in the worlds are basically running S&P 500 index funds except where they’ve chosen to deviate from the S&P is in the worst three possible sectors given the current economic environment.  

Steve Halpern:  Now drilling down even a further level, you note this is a significant allocation just to a handful of tech stocks.  Can you comment on that?

Landon Whaley:  Sure, yes.  The top three stocks that are owned by these firms just based on dollars invested are Apple (AAPL), Microsoft (MSFT), and Google (GOOGL), and as I mentioned just a second ago, these funds are overweight to technology factor and a big chunk of that overweigh allocations is in these three stocks.  

This is concerning primarily for two reasons.  First, if growth in the U.S. continues to slow, or if the fed hikes rates into this dismal economy and causes a recession, technology is going to be one of the worst performing sectors.  

Second, one of the things we monitor is fund flows into and out of all sectors and all markets, and by watching that, I can tell that the shift away from technology has not happened yet.  Once the rest of the world wakes up and realizes that U.S. growth isn’t hitting the estate velocity anytime soon, you’ve got to watch out.  

When these hedge funds decide to cut base, everyone invested in these three companies is going to feel it.  The time to get out is before the stampede at the door has begun, not after.  

Steve Halpern:  Now in addition to having commentary for your subscribers on your market outlook and strategy, you also maintain portfolios at the day traded funds that back up your market positions.  Could you walk us through some of the long and short ETF recommendations that you currently have?

Landon Whaley:  Absolutely, yes.  Right now, I trade everything off of themes and so the two main themes I’m trading on right now, one is slowing global and U.S. growth, and the second one is the divergent and monetary policy.  

Specifically, the fact that a number of central banks around the world are going to negative interest rates while the U.S. and the fed is still pursuing normalization. So, based on these two themes, there are three primary trades that I really love right now.  

The first one I would be sure with the S&P 500.  For one, the level of corporate defaults this year is on a pace not seen since the crisis.  Two, corporate earnings have been falling for multiple quarters in a row.  Three, the S&P 500 has diverged from emerging market equities for the third time in the last nine months.  

Now this last one is important because the prior two times the S&P rallied higher while emerging markets were rolling over, the S&P went on to decline at 11% both times.  The second trade I like is being long US treasuries.  Whenever there are growth concerns, either foreign or domestic, it’s bullish for US treasuries, and we’re currently in an environment where we have both of those things working in our favor.  

Global growth concerns are bound because none of the major players can seem to put together more than a month or two of decent data.  In the US, we can use the spread between 10-year and two-year treasuries as an indication of what investors are expecting from U.S. growth.  

That spread is currently at the flattest it’s been since 2007, which means investors don’t have much hope for US growth.  Both of these points are extremely bullish for US treasuries.  

The final trade I love is the being long gold.  Gold, no matter what you hear from others, gold is simply a trade on interest rates and it performs best when interest rates are falling or are low.  

As we mentioned earlier, most of the world central banks are running out of things to throw at their economy and so they’re turning to negative interest rates as the next best thing.  Well, if low interest rates are good for gold, negative interest rates are great for gold.  

Steven, the beauty of all three of these trades with all of the banter around the fed hike or not hike in June is that all of them are going to work when said hikes in June are not.  

In fact, I go into a great detail about these trades and a couple of others in this week’s Whaley Report and be happy for our listeners to get a free copy just by going to our website.  

Steve Halpern:  Great.  I appreciate your time today.  Again, our guest is Landon Whaley of The Whaley Reports.  Really appreciate you talking with us.  

Landon Whaley:  It was my pleasure, Steven.  Thank you again for having me.

By Landon Whaley, Editor of The Whaley Report