Having grown up in Kenya and spent lots of time in the African savannah, I have always been fascinated by herd behaviour. The annual wildebeest migration sees over two million animals migrate to find greener pastures. In their quest they may be hunted, stalked and run down by larger carnivores. For the wildebeest, following the herd is not just a good idea – it can be a lifesaver for susceptible animals looking for safety from predators.
In financial markets, investors want protection too, especially when uncertainty is widespread. But seeking shelter by following the herd can leave you more exposed than protected. There’s a fine line between positive and negative herd mentality.
Academics and behavioural finance experts have attempted to identify and predict the rational and irrational behaviour of group think in order to help predict future economic outcomes. Behavioural finance teaches us that herding is a natural human instinct driven by emotional reactions such as greed and fear. But it’s also something to be wary of – investors rushing to be part of the latest trend can often lead to asset bubbles forming, such as the dot.com boom and bust of the late 1990s. The bull market of recent years has been characterised by extremely risk-averse investor behaviour, as record low interest rates and macro uncertainty has encouraged a stampede into defensive bond proxy-like sectors in the search for safe havens and a continued hunt for yield. This has led to crowded trades in certain sectors and stocks.
What is crowding and what are the risks?
Crowding is an over-representation of stocks in the portfolios of active managers – the consensus trade. It tends to be measured by such factors as institutional ownership (through active bets and trade persistence), sentiment (price momentum and sell-side analysts’ ratings) and expectations (earnings forecasts and valuation).
Investors may feel comfortable and secure in these ‘crowded trades’. As British philosopher Bertrand Russell pointed out “collective fear stimulates herd instinct, and tends to produce ferocity toward those who are not regarded as members of the herd.”
But it’s important to be aware of the inherent risk in these holdings and to consider breaking from the herd, even when your emotions tell you otherwise. The differences in valuation between safe-haven assets and all others are at an extreme. You could liken this to an elastic band that’s been stretched further and further – waiting to snap back. The consequences for investors taking shelter in these perceived ‘low risk’ crowded assets could well be severe if we see any unravelling.
Crowded stocks tend to have an asymmetric return profile – incremental positive news is generally of little benefit, because there is little room to improve on already high expectations. Conversely, negative news carries much more downside risk given stretched valuations. The reverse is true of oversold companies; already negative sentiment puts a floor on negative revisions, whilst positive surprises provide powerful impetus on the upside.
Balancing crowded holdings with uncrowded holdings can therefore help to mitigate downside risk by offering diversification through negatively correlated returns.
So what’s crowded now?
The following chart shows which sectors globally have the highest concentrations of the most crowded stocks (rather than just the most crowded sector as a whole). It looks at it in two ways – on an equally-weighted basis (ie, each stock counts equally within the sector) on the y-axis and on a market cap-weighted basis (x-axis).
Healthcare, technology and consumer staples are the most crowded sectors globally with their earnings stability and relative growth prospects in a slow-growth economic environment proving a magnet for investors. On the flipside, the least crowded global sectors are financials and energy – unsurprising given the continued move to low and negative rates and the depressed oil price that has driven sentiment and valuations to multi-year lows. More recently the energy sector has experienced increased investor interest, but it remains the second most underweight sector.
Breaking from the herd
So how can a better understanding of crowding help investors? While measures of crowdedness are clearly interesting, on their own they may not be enough to indicate opportunities. It’s also important to look out for catalysts that may indicate future performance reversal, for example a change in the direction of sentiment, where ratings and earnings estimates are starting to improve or being revised or where valuations have reached fundamental support levels. If you pay too high a price for a low risk asset you are changing the level of risk you take. In the current environment, the opportunity is in those areas that are out-of-favour and we have rarely seen the value in some segments of the market that we see today. While defensives are likely to continue to be in favour given the political and economic uncertainty, investors need to be cautious buying into this already crowded space.
What will release the already stretched elastic band? The longer they persist and the further they move away from fair value, the greater the chance the crowded trades will unravel. Once these trades reach an unsustainable valuation, or an exogenous shock occurs, we could see a sharp price reversal as investors unwind their exposure in tandem. The combination of better global growth and slightly higher rates could be the trigger for a snap-back in valuation differentials between perceived low risk assets and the rest of the market.
The proverbial ‘crowded trade’ can lure investors like lemmings over the edge of a cliff. Gaining traction on your investment portfolio is not about following everyone else; it’s about seeking value and opportunity from stocks with sound fundamentals – no matter what anyone else is doing. Awareness of crowded areas can, at the very least, help investors with portfolio construction, and for the more adventurous, highlight unloved areas that may lead to attractive returns in the future. Perhaps most important of all, an awareness of crowding may help investors to avoid being trampled in the stampede when those positions start to unwind.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.