What you need to know about "crowdedness" risk and return

A Yogi Berraism: At Ft. Lauderdale Yogi was listening to his teammates talk about a restaurant in the area. Said Yogi, “Aw, nobody ever goes there. It’s too crowded.”

There always has been a significant interest in trade crowdedness, or more specifically, the big trades of hedge funds. However, there is a yin and yang with crowdedness. We want to know what smart money is doing so we can follow it, but we realize that if everyone is following the trades of others there will be a tipping point where the crowd will kill the golden goose trade. This is another way of saying the mix of buyers and sellers has an impact on the future direction of prices especially if there is a crisis. The structure or composition of funds and markets matters.  

Now crowdedness has not been well-defined, but a good measure is the numbers of days to liquidate equity positions held by hedge funds. Research has found that crowdedness as measured by the position-taking of hedge fund managers through the 13F filings will generate positive excess returns of approximately 300 bps versus stocks that are not crowded. (See "Crowded Trades and Tail Risk") 

This new crowdedness factor seems to be independent of other key equity risk factors. The collective wisdom or information edge of hedge fund managers along with their buying power seems to find stocks that will generate good positive relative returns. But there is a catch.

A close review of the crowded portfolios of hedge fund managers shows strong decline in returns or drawdowns when there is a negative market environment or crisis. Crowded trades do well until the market faces stress that may require liquidation. Investors will receive compensation for holding these crowded trades, but they will pay a price when there is a flight to the exits like during the GFC. Trying to piggy-back on the smartness of others can work, but when this collective smartness needs to find the exits, the market decline will be strong. The negative case is very specific, but it does suggest that following the action of others will have downside during a market unwind.