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 (E&P) herding, we followed the approach of our earlier work on aggregate and sector-specific 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

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, OXY, and EOG.) The crowded bets are likely to deliver negative risk-adjusted returns in flat or declining oil and gas producer cycle.

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.

Summary

• 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.

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A Survey of Pershing Square’s Security Selection and Market Timing

Not all outperformance is true outperformance. There are many funds whose performance looks spectacular on the surface, but whose risk-adjusted performance is poor. This article takes a closer look at Pershing Square Capital Management, nominally one of the top performing funds throughout 2014 and over the long-term. We show that the risk-adjusted performance of Pershing’s reported long equity positions is, in fact, impressive. We also delve into sectors and factors behind these outstanding risk-adjusted results.

Risk-Adjusted Performance Defined

The AlphaBetaWorks (ABW) Performance Analytics Platform identifies risk-adjusted performance as αβReturn – performance relative to a passive replicating portfolio. αβReturn consists of performance due to security selection (αReturn) and market timing (βReturn). αReturn is the return a fund would have generated if markets were flat. βReturn is the return a fund generated by varying its factor exposures.

Pershing Square – Risk-Adjusted Returns

The fund’s 10-year long αβReturn is around 300%, while passive long return is over 500%. Below we illustrate Pershing’s overall active return (αβReturn) and passive return over the past ten years. The purple area highlights cumulative positive active return; cumulative passive return is the gray area underneath:

Pershing Square Capital Management Historical Passive and Active Returns – Long Equity Portfolio

Below we provide the components of Pershing’s estimated annual returns. Active returns (αβReturns) are broken down into security selection, or stock picking, (αReturn) and market timing (βReturn). Most of the 2014 return is active: roughly two thirds from stock picking and one third from market timing.

We will now delve deeper into the sources of Pershing’s high risk-adjusted returns – the sectors and the factors that contributed most to αβReturn.

Pershing Square – Long Equity Security Selection

αReturn is the risk-adjusted return from security selection – the return a fund would have generated if markets were flat. Pershing’s recent and 10-year results are stellar:

Pershing Square Capital Management Historical Security Selection Return – Long Equity Portfolio

Furthermore, Pershing’s trailing three-year annualized αReturn of 5% exceeds αReturns of 81% of its peers:

Pershing Square Capital Management 3-year Sector Security Selection Return vs. Peers

Sector Security Selection

Digging deeper, most of the 2014 αReturn came from the Industrial and Consumer sectors. Over history, there have been a few years of especially large positive (and negative) sector-specific αReturns:

The Industrial sector is an area of consistent strength:

Pershing Square Capital Management Industrial Sector Security Selection Return – Long Equity Portfolio

Pershing’s recent long positions in the industrial sector are:

Pershing’s Consumer sector αReturn has been mixed over the past 3 years; it has been excellent over the long-term and in 2014:

Pershing Square Capital Management Consumer Sector Security Selection Return – Long Equity Portfolio

Pershing’s recent long position in the consumer sector is:

Additional security-selection insights, such as position sizing skill and the analysis of portfolio scalability/overcapitalization, are available but beyond the scope of this article.

Pershing Square – Long Equity Market Timing

βReturn is the risk-adjusted return from market timing – the return due to variation in factor exposures over time. Positive βReturns occur when a manager takes on larger exposures to factors that subsequently generate larger-than-typical returns.

Pershing Square has varied factor and sector exposures dramatically over time. In the chart below, the red dots depict historical long portfolio factor exposures, while the diamonds show current exposures. Critically for skill evaluation, ABW’s non-market risk factors exclude all market effects, which enables sound performance attribution:

Pershing Square Capital Management Historical Factor Exposures – Long Equity Portfolio

Pershing Square’s factor timing performance (βReturn) was negative from 2004 to 2006, largely flat through 2012, and positive since 2012:

Pershing Square Capital Management Historical Market Timing Return – Long Equity Portfolio

Similar to analyzing αReturns by sector, AlphaBetaWorks analyzes specific sources of βReturn to identify which factors the fund has timed successfully, or unsuccessfully. For example, In 2014 Pershing’s positive market-timing returns were due to:

• Increased exposure to the U.S. Health, Canada Market, and Canada Industrial factors;
• Decreased exposure to the U.S. Consumer factor.

Pershing Square’s significant βReturn components, by year:

Conclusion

• Risk-adjusted performance is return above a passive portfolio replicating a fund’s typical risk profile.
• Pershing Square exhibited strong risk-adjusted return from overall security selection (αReturn) and, recently, strong market/factor timing (βReturn).
• Pershing Square recently exhibited especially strong risk-adjusted security selection returns (αReturns) in Consumer and Industrial sectors.
• Pershing Square recently exhibited strong risk adjusted market timing returns (βReturns) due to increased exposures to the U.S. Health, Canada Market, and Canada Industrial factors, and reduced exposure to the U.S. Consumer factor.
• Among its many advantages, our analysis provides allocators insights into manager core competencies. Portfolio managers, too, benefit from deeper understanding of their own – and their teams’ – strengths and weakness.

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.

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