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Hedge Fund Clustering: Q2 2015 Update

Hedge Fund Clustering: Q2 2015 Update by AlphaBetaWorks Insights

Fund crowding consists of investment bets shared by groups of funds – large pools of capital chasing similar strategies. Within the hedge fund industry, long equity portfolios crowd into several clusters with similar systematic (factor) and idiosyncratic (residual) bets. This hedge fund clustering is the internal structure of hedge fund crowding.

This piece illustrates the large-scale hedge fund clustering and examines the largest hedge fund cluster in which:

  • Factor crowding is due to two factors;
  • Residual crowding is moderate and four stocks-specific bets stand out.

Allocators who are unaware of hedge fund clustering and hedge fund crowding may be invested in an undifferentiated portfolio, paying active fees for passive factor exposure.

Hedge Fund Crowding and Hedge Fund Clustering

Several of our earlier articles on hedge fund crowding analyzed the factor (systematic) and residual (idiosyncratic) bets of HF Aggregate, which consists of the popular equity holdings of all long U.S. hedge fund portfolios tractable from regulatory filings.

Analysis of overall industry crowding does not address bets shared by fund groups within the aggregate. To explore this internal structure of hedge fun crowding – clusters of funds with shared systematic (factor) and idiosyncratic (residual) bets – in 2014 we released pioneering research on hedge fund clustering. The 2014 work proved predictive and invaluable to allocators. This piece updates the analysis of hedge fund clustering with Q2 2015 holdings data.

Hedge Fund Clusters

To explore hedge fund clustering we analyze long portfolios of every pair of Hedge Funds analyzable using regulatory filings using the AlphaBetaWorks’ Statistical Equity Risk Model, a proven tool for forecasting portfolio risk and future performance. For each portfolio pair we estimate the future relative volatility (tracking error). The lower the expected relative tracking error between two funds, the more similar they are to each other.

Once each hedge fund pair is analyzed – hundreds of thousands of factor-based risk analyses – we identify groups of funds with similar factor and residual exposures and build clusters (similar to phylogenic trees, or family trees) of the funds’ long portfolios. We use agglomerative hierarchical clustering with estimated future relative tracking error as the metric of differentiation or dissimilarity. The result is a picture of clustering among all analyzable U.S. hedge funds’ long portfolios:

Clusters of U.S. Hedge Funds’ Long Equity Portfolios: Q2 2015

The largest cluster contains approximately 50 funds. A number of portfolios had exposures that were so similar, we expect their relative annual volatility to be under 3% – their annual returns should differ from one another by less than 3% about two thirds of the time.

This is critical for allocators: if they are invested in clustered funds, they may...