Hedge Fund Hotel Stocks Tanked In Q3 And That Could Be A Good Test For Wall Street

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As hedge fund returns for the third quarter filter in its clear some of the most widely-owned positions among stock-oriented funds led the market lower during the past month’s correction. In fact, financial data analytics firm Novus said in a note yesterday the third quarter may be the worst for hedge funds in terms of index under-performance since global financial crisis of 2008.

The major issue appears to be a high concentration, or crowding, among hedge funds in a handful of stocks. As of Wednesday evening, Novus found that its list of the most owned stocks in the portfolios of large hedge funds fell over 22%, a far sharper drop than the S&P 500 Index’s tumble. (Novus defines crowds as a 50/50 mix between the number of hedge funds owning a stock, and the percentage of shares they own)

Nine crowded hedge fund stocks fell over 20% during the quarter, led by Platform Acquisition Holdings, Community Health Systems, Cheniere Energy and Valeant Pharmaceuticals , which all dropped in excess of 25% as of Wednesday’s close. Other highly concentrated hedge fund stocks such as SunEdison and TerraForm Power, or Axovant Sciences, Howard Hughes Corporation and Loral Space & Communications have also seen their shares tumble well more than stock market indices.

For widely followed hedge fund managers ranging from Pershing Square’s Bill Ackman to Greenlight Capital’s David Einhorn, Carl Icahn and Richard Perry of Perry Capital, those tumbling stocks have created challenges that may rekindle memories of the 2008 global financial crisis. Einhorn is down over 17% year-do-date, Ackman’s fund lost over 15% during the quarter and many of Icahn’s biggest positions in the energy and technology sector tumbled.

One problem for hedge fund managers is a big overlap between positions. Amid indiscriminate selling, particularly among companies sensitive to changes in the global economy or commodities prices, many of stocks with high hedge fund ownership — so-called hedge fund hotels — fell the most. Stan Altshuller, author of Novus’s report tells FORBES he believes the hedge fund stock washout is fairly predictable and could reverse course.

In previous market corrections, for instance July 2011 or May 2012, concentrated hedge fund holdings underperformed as active managers spooked by the market sold their most liquid positions. But then the stocks rebounded.

“I don’t think this correction is going to be very different than the ones,” says Altshuller. “I have never seen a correction such as this, a deep three month negative alpha, that has never not been followed by long periods of positive alpha,” he adds.

Perhaps, some active investors and hedge funds will find that the present market drop has created opportunity. Besides being a moment where value in has returned, the market drop of August and September may also help distinguish between hedge funds strategies.

As many funds have grown larger, turned to shareholder activism, and decided to concentrate their portfolios in search of above average returns, they’ve minimized their use of leverage. That could reduce the risk of margin calls or distressed liquidations. To make bold bets, often involving greater than 5% control of shares in a company, funds have also been on the hunt for permanent sources of capital that aren’t susceptible to the redemptions of flighty limited partner investors.

Many once-exclusive hedge funds have floated some variation of their portfolios in public stock markets.

Greenlight Capital, Third Point Capital and Paulson & Co. invest large portfolios inside publicly traded reinsurers. Pershing Square’s Bill Ackman last year floated a piece of his portfolio on stock markets in Amsterdam, nearly doubled his hedge fund’s so-called permanent capital. And then there’s Carl Icahn, who in response to the global financial crisis dissolved his hedge fund, Icahn Capital, and put all of his assets into a publicly traded vehicle called Icahn Enterprises.

All of these moves are intended to give hedge funds the ability to make bold investments without worrying about the risk limited partners redeem their holdings then the road gets rough. As the crisis of 2008 showed, investors often pull their money from stocks and hedge funds exactly at market lows — times when they should be doubling down.

If, as Novus claims, the third quarter was the worst in underperformance for concentrated hedge fund investments, it may give insight into how the industry’s changed. Many hedge fund radically altered their structures in the wake of the financial crisis in search of stability, and the recent turmoil could be a good litmus for what works.

Antoine Gara

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