Hedge Fund Conviction Takes Off, and Consensus is Catching Up

Novus has four indices that help track important trends in the hedge fund (HF) industry: Conviction, Consensus, Crowdedness, and Concentration. These are collectively known as the Novus 4C Indices. Our Novus Hedge Fund Universe (HFU)—the foundation for the Novus 4C’s—is an aggregate of all investment mangers’ public filings that examines which positions meet the criteria to be considered a Conviction or Consensus name. These indices equally weight the top twenty names that meet that criteria each quarter. By evaluating the indices via the HFU, we decompose the drivers of return and identify any changes occurring in these indices and the industry.

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Performance in 2017

Conviction and Consensus outperformed the MSCI World and S&P 500 through December. There was also very little turnover during Q3 2017. (Crowdedness and Concentration, however, underperformed and did experience turnover.) Let’s examine Conviction and Consensus to learn about their impressive years.

Conviction Allocations and Outperformance

The Conviction Index is comprised of names chosen based on the number of hedge funds reporting positions at 5% or greater. Currently, managers have considerable conviction toward Technology and Consumer Discretionary, with Technology becoming more heavily favored as Healthcare and Consumer Staples have waned.

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The Conviction index heavily outperformed the market thanks to its sector tilts and security selection. 754bps (or 20%) were generated because of the sector tilts, and 849bps (or 22%) of overall contribution is from security selection.

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Breaking it down further, Technology, Financials, and Industrials generated security selection alpha.

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BABA, PYPL, AABA, and AMZN drove this outperformance along with other familiar names–some FANG included. Despite a reputation as performance drivers, the FANG names weren’t actually top generators of outperformance.

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Consensus Allocations and Outperformance

The Consensus index removes the conviction threshold, looking only at the number of managers reporting a given name. Therefore, it includes names based on popularity. Like the Conviction index, this index also skews largely toward Technology, but it has slightly more sector diversification with steady allocations to Financials and Healthcare.

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The Consensus index also outperformed from sector allocation and security selection, but it didn’t generate as much alpha: 575bps (or 18%) was contribution from sector allocations and 400bps (or 12.5%) was from security selection.

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Technology, Financials, and Consumer Discretionary generated security selection alpha. (Both Conviction and Consensus saw alpha generation from Technology and Financials.)

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You’ll see below that the top securities overlap with the Conviction index—BABA, AMZN, and BAC.

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The Conviction index’s additional outperformance (above Consensus) stems from technology names like PYL, AABA, and TDG, but both indices have a decent overlap in their top ten alpha generators.

But, has this always been the case?

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Conviction and Consensus Overlap

Novus’ overlap functionality reveals the current overlap between the indices below. As of the most recent filings in September, the Novus Conviction and Consensus index had a 65% overlap—thirteen of the twenty names are the same. There is very little overlap—if any—between Conviction and Consensus and the other two 4C Indices, Crowdedness and Concentration.

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Over the past four years, overlap between Conviction and Consensus averaged at 46% and currently stands at a high of 65%. Managers’ conviction names have become increasingly popular across hedge funds. There are multiple reasons why Conviction and Consensus are converging, but one theory stands out as a potential risk. As high-conviction names outperform, they attract other managers and market participants. These “follower” managers are allocating less capital with less conviction. These lower-conviction positions help fill out a manager’s long exposure while providing decent returns with low risk because everyone is invested. In a downturn, these names are the first to be cut once they fall out of favor.

The Conviction index’s overlap to the S&P 500 increased 13% to 20%, reflecting how both indices have become more Technology focused. The Consensus index has always had a higher overlap, averaging at 25%, which is expected because the most popular names have a lot of capital allocated to them from across the market, not just hedge funds.

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Conclusion

Conviction and Consensus both outperformed in 2017, primarily driven by Technology and Financial names. These names have historically had moderate overlap, which has now reached a four-year high. This convergence poses a potential risk for managers invested in a Conviction/Consensus name, and will be something to watch in the coming quarters. As 2018 progresses, Novus will continue following the 4C indices’ performance and overlap to identify potential risks or opportunities for investment managers.

All Novus clients can evaluate the Novus 4C Indices on the Novus Alpha platform.

Investors who would like to participate in these themes via investable products can contact Barclays. Check our website for an explanation of how Novus data is used to build these indices.