Investors pay more than their fair share of attention to cycles in business, the economy, and markets — and their own behavior can be just as predictable.
Savita Subramanian, the head of US equity strategy and quantitative strategy at Bank of America Securities, says that one easy way to improve returns tomorrow is to look at what some long-only investors won't buy today — because almost inevitably, those stocks will have a moment in the sun.
"The strategy of buying the 10 most underweight stocks and selling the 10 most overweight stocks [by active funds] each year has generated an average of 5ppt to 18ppt of alpha per year, with the exception of 2017 and 2020," she wrote in a recent note to clients.
She suggests that the flow of investors' money out of actively-managed funds and into cheaper passive funds is causing this to happen. That flow has been one of the most important dynamics in investing over the last few years, and it's a pattern that will continue to occur.
"We believe this should continue, as the main driver of the most crowded stocks' weakness - outflows from active fund into passive vehicles - is likely far from over," Subramanian said.
Many of those funds track major indexes like the S&P 500. When a stock is under-owned by hedge funds, those passive vehicles essentially drag its ownership back to the benchmark. Subramanian uses the positioning and activity of long-only (LO) hedge funds to get cues for the stocks where the trade is likely to work.
"In addition to the level of LO positioning, there is also an alpha signal in the change of LO positioning, where stocks with decreasing LO crowding risk have historically outperformed those stocks with increasing crowding risk," she said.
That is to say, if stocks that are under-crowded have more potential than those that are already popular, stocks that are actually losing favor among hedge funds have outperformed those that are getting more attention. Subramanian adds that comparing the stocks to a benchmark and evaluating their relative weight makes the signal work better.
"Based on the average rank of (1) three-month decrease in LO relative weight and (2) the level of HF net relative weight, stocks within the top quintile have outperformed the bottom quintile by 20% since September 2011," she wrote.
These are the stocks hedge where funds have the most exposure relative to the S&P 500. That's where Subramanian recommends selling.
- Baker Hughes (BKR)
- Chipotle Mexican Grill (CMG)
- EOG Resources (EOG)
- Carrier Global (CARR)
- Netflix (NFLX)
- NetApp (NTAP)
- Caesars Entertainment (CZR)
- Royal Caribbean Group (RCL)
- LyondellBassell Industries (LYB)
- Cigna (CI)
And these are the stocks with the lowest levels of relative exposure from long-only funds. Stocks in that position have outperformed in the recent past.
- Under Armour (Class C) (UA)
- People's United Financial (PBCT)
- Alliant Energy (LNT)
- Leggett & Platt (LEG)
- Amcor (AMCR)
- Unum Group (UNM)
- Consolidated Edison (ED)
- Rollins (ROL)
- Assurant (AIZ)
- NiSource (NI)
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