The massive and seemingly broad gains in the stock market in recent weeks have concealed a striking and potentially risky trend. The top 50 stockholdings of mutual funds and hedge funds, whose investment approaches typically differ, have a near-record degree of similarity, according to a study by Bank of America Merrill Lynch. "This huge world of investible assets has shrunk down to a small cohort,” observes Savita Subramanian, head of U.S. equity quantitative strategy at BofAML. “We’re all in this echo chamber where everyone goes to the same dinners and drinks the same Kool-Aid,” she adds. The trend was detailed in a story by The Wall Street Journal as outlined below.

Mastercard Inc.(MA), Microsoft Corp. (MSFT), Amazon.com Inc. (AMZN), Abbott Laboratories (ABT), and PayPal Holdings Inc. (PYPL) were identified by analysts at Bernstein as being among the most crowded trades among institutional investors, the Journal adds. Meanwhile, short interest in the FAANG stocks, Facebook Inc. (FB), Apple Inc. (AAPL). Amazon.com, Netflix Inc. (NFLX), and Google parent Alphabet Inc. (GOOGL), is at all-time lows, per BofAML.

Key Takeaways

  • Mutual funds and hedge funds are crowding into the same few stocks.
  • Short interest in the FAANG tech stocks is at an all-time low.
  • Should these stocks tumble, the overall market may plummet.

Significance For Investors

The convergence between the holdings of mutual funds and hedge funds is especially troublesome. The problem with crowded trades is that, once sentiment shifts and these large institutional investors all start selling their current favorites at the same time, a massive market pullback becomes increasingly likely.

A sell-off in tech stocks sent the S&P 500 Information Technology Index plummeting by 24.4% from top to bottom in 4Q 2018. That, in turn, was a major contributor to an overall decline of 19.6% in the S&P 500 Index (SPX), a hair short of bear market territory, during the same time frame, per S&P Dow Jones Indices.

Market contrarians interpret the low level of short interest in the FAANG stocks right now as a sign of excessive optimism about their prospects, if not full-blown irrational exuberance, and thus a bearish signal. As a group, the FAANG stocks account for 15.9% of the value of the S&P 500, per SlickCharts.com.

Add the other overcrowded stocks mentioned above (Mastercard, Microsoft, Abbott Labs, and PayPal) to the FAANGs, and just these 9 equities have a collective weight of 22.5% in the S&P 500. A wave of selling that spreads through these popular holdings is bound to have a similar effect on the overall market as did the tech selloff in late 2018.

According to a study by UBS based on fund holdings at the close of 1Q 2019, the most overweight equity positions among active mutual fund managers at that time were, in descending order, Visa Inc. (V), Alibaba Group Holding Ltd. (BABA), Alphabet, Microsoft, and Mastercard, per a report in Barron's.

Looking Ahead

The market, overall, is dramatically higher than its peak last year. And while these stocks seem unstoppable now, they may begin to heavily sell off if shaken by an exogenous force. No one knows when that would happen, but such an event has the potential to fuel declines that are as steep, or steeper, than the ones that have shaken investors in the past 18 months.