U.S. hedge funds share a few systematic and idiosyncratic long bets – a phenomenon called “crowding.” Hedge fund crowding within specific sectors can be heavy; bets on exploration and production (E&P) companies are particularly crowded. Hedge fund E&P bets are the subject of this article. Eight stocks are responsible for three quarters of the herding.
Crowding is costly to investors, fund managers, and allocators: over the past 10 years the aggregate hedge fund E&P portfolio underperformed the market E&P portfolio by 23% while taking more risk. The risk-adjusted return was even worse – a loss of 52%.
Identifying Hedge Fund E&P Crowding
To evaluate hedge fund (HF) exploration and production
) herding, we followed the approach of our earlier work on aggregate
hedge fund crowding: We created an aggregate position-weighted
portfolio (HF E&P Aggregate
) consisting of all exploration and production long equity positions reported by over 400 U.S. hedge funds with medium to low turnover. We then evaluated HF E&P Aggregate’s risk relative to the capitalization-weighted portfolio of E&P equities (Market E&P Aggregate
) using AlphaBetaWorks’ Statistical Equity Risk Model.
Crowded E&P Stocks Underperform
Crowding hurts performance. HF E&P Aggregate had poor returns following the peak
of the last energy cycle
in 2008. Consequently, understanding Hedge Fund E&P crowding is vital to investors, fund managers, and allocators.
When the broad market and the E&P sector are doing well, crowded hedge fund E&P stocks generally outperform. However, these stocks generally underperform in the down cycle. This is a tell-tale sign of flocking to higher-risk stocks. This crowding towards higher market and sector betas
is consistent with the aggregate systematic crowding of hedge funds
Historical Return for Hedge Fund E&P Aggregate vs. Market E&P Aggregate
Indeed, we will see later that hedge fund E&P aggregate has both higher market exposure (market beta)
and higher E&P sector exposure (E&P sector beta)
than the market E&P Aggregate.
When we adjust for the systematic (factor) risk, we discover that the residual
return of HF E&P aggregate due to security selection
is even worse. Investors would have made 52% more over the past 10 years if they had invested in an ETF portfolio with similar factor risk:
Historical Hedge Fund E&P Aggregate, Factor, and Residual Returns
Hedge Fund E&P Risk
HF E&P Aggregate has a 5.0% estimated future tracking error
relative to Market E&P Aggregate, primarily due to stock-specific bets:
Sources of Relative Risk for Hedge Fund E&P Aggregate
||Share of Variance (%)
The 5.0% tracking error means that HF E&P Aggregate’s annual return is forecasted to differ from Market E&P Aggregate’s by less than 5.0% two thirds of the time.
Hedge Fund Factor (Systematic) E&P Crowding
On the chart below, HF E&P Aggregate’s factor exposures (red) are similar to Market E&P Aggregate’s (gray), but tend to be higher. Hedge Funds tend to invest in names with higher market and sector betas, perhaps as a logical consequence of their compensation structure:
Hedge Fund E&P Aggregate’s Exposure to Significant Risk Factors
Hedge Fund Residual (Idiosyncratic) E&P Crowding
Over 75% of the relative risk of HF E&P Aggregate is due to stock-specific (residual) bets. Below are the sources of HF E&P Aggregate’s relative residual variance. Three quarters of the estimated relative residual risk is due to only eight stocks:
Stocks Contributing Most to Relative Residual Variance of Hedge Fund E&P Aggregate
As with HF Energy Aggregate
, some of the largest bets are not the stocks hedge funds own, but the stocks they don’t own. (For example, hedge funds are underweight COP
, and EOG
.) The crowded bets are likely to deliver negative risk-adjusted returns in flat or declining oil and gas producer cycle.
||Athlon Energy, Inc.
||Chesapeake Energy Corporation
||Occidental Petroleum Corporation
||EOG Resources, Inc.
||Cobalt International Energy, Inc.
||Canadian Natural Resources Limited
||EP Energy Corp. Class A
||Talisman Energy Inc.
||SandRidge Energy, Inc.
||Continental Resources, Inc.
||Crocotta Energy Inc.
||Whiting Petroleum Corporation
||Noble Energy, Inc.
||Pioneer Natural Resources Company
||Marathon Oil Corporation
||Oasis Petroleum Inc.
||Paramount Resources Ltd. Class A
||Athabasca Oil Corporation
Of course, the poor long-term performance of the HF E&P aggregate does not mean that some individual equities will not do well. In fact, in the third quarter of 2014, ATHL was acquired
. With half of the shares owned by hedge funds, ATHL was one of the largest positions of HF E&P Aggregate and the top idiosyncratic bet.
- Hedge Fund Exploration and Production (E&P) Aggregate tends to have higher risk than Market E&P Aggregate.
- Crowded Hedge Fund E&P stocks tend to underperform market aggregate over the long-term, in spite of higher risk.
- Crowded Hedge Fund E&P stocks tend to generate negative risk-adjusted returns.
- There is both factor (systematic/market) and residual (idiosyncratic/security-specific) crowding of long hedge fund E&P portfolios.
- Over 80% of recent crowding is attributable to eight stocks: ATHL, CHK, COP, OXY, EOG, CIE, CNQ, and EPE.
The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2014, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.