How can hedge funds possibly thrive in this world? Go big, or go home.
Even before the pandemic hit, funds with large, concentrated bets were gaining market share. Last year, event-driven funds, which seek to profit from certain situations like mergers or takeovers, saw $11 billion of inflows, while the hedge fund industry as a whole witnessed more than $100 billion of withdrawals, estimates eVestment Inc., a Nasdaq Inc. company.
This is for good reason. Fund managers who consistently outperform tend to trade less, have higher tracking errors and more concentrated portfolios, Bernstein Research finds, using data from 2006 to 2019. Among top-performing managers, 27.7% have the most concentrated portfolios, compared with just 19.3% for the bottom fish.
This is perhaps not surprising. Star managers tend to have the strongest conviction — concentrated bets, as well as sharp deviation from benchmark indexes, are just expressions of that. Billionaire investor Stanley Druckenmiller certainly dispels the merit of diversification, calling the stuff people learned in business schools “the most misguided concept” in a speech five years ago.
Covid-19 has made the transition even more extreme. A fast-changing market structure means there’s now even less benefit from a diversified portfolio.
We learned from the selloff earlier this year that risk parity trades, pioneered by Ray Dalio, don’t always work. Every asset class, from haven Treasury bonds to stocks, was tumbling. In fact, Dalio’s $148 billion Bridgewater Associates LP, which is all about diversifying away risks, has run up hefty losses this year and is nursing billion-dollar withdrawals from big clients. In March, the S&P Risk Parity Index that targets 10% volatility tumbled more than 20% from peak to trough.
Meanwhile, within the equity space, correlations across the S&P 500 have risen, to as high as 90% in March, and again to 75% in July. What’s the point of a diversified portfolio if everything rises and falls together? The benefit of holding many stocks is dwindling.
In addition, as hedge funds’ most prized clients — from pension to endowment funds — make a big shift toward ESG, only managers with concentrated bets can say, in a meaningful way, that their investments are kosher. It’s much easier to be an activist and focus on deeper dialogue with company management if you only need to nurture a few open positions. Event-driven funds again saw inflows this year, even though activist funds are in the red, data provided by eVestment show.
Of course, the temptation is to just follow the footsteps of Masayoshi Son, now nicknamed the Nasdaq whale, and crowd into the same bundle of Big Tech stocks. That would be a bad idea, because it’s not an expression of conviction, but a momentum play that will only end in tears. Plus, Masa Son was dipping into these stocks just for “treasury operations,” to earn some returns for the cash he was sitting on. Son was simply day trading; he wasn’t trying to make a career out of stock investing.
If you see something that excites you, put all your eggs in one basket and watch the basket very carefully, advised Druckenmiller. That’s even truer now than it was five years ago, given over 20% of the S&P 500 Index is dominated by just five tech names. Since diversification is dying, perhaps the only way to beat a concentrated market is to go active, and make a few smart, concentrated bets yourself.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron’s, following a career as an investment banker, and is a CFA charterholder.