Monthly Archives: June 2012

What Is a “Crowded Trade” and How Can It Effect You

Occasionally on one of the financial networks when they are interviewing a money manager or hedge fund operator you will hear the term “crowded trade”.  While a “crowded trade” is difficult to pin down definition-wise, maybe it’s best to convey what a crowded trade is by describing various characteristics that make up a crowded trade:

  • Periods of fast price appreciation seemingly by leaps and bounds, signifying large numbers of participants entering the trade.
  • The vast majority of participants share almost identical beliefs about the underlying investment, increasingly at sometimes almost maniacal, fever pitch levels.
  • A high percentage of the participants are of the short term speculators looking to make a “quick hit”, get in and get out.

Now picture if you will an empty movie theater an hour before show time. It starts out empty and only a single door needs to be open to handle the numbers of movie-goers coming in. As the patrons arrive and take their seats, their numbers are few and conversations likewise. As show time approaches,  more and more patrons arrive and more doors are opened up to handle the influx. This represents the price moving up rapidly. The higher the price, the more patrons of the stock can be allowed in.

Soon the theater gets close to full and conversations are at a fever pitch, as all are in agreement, anticipating the show. Eventually, close to all the fans are in the theater and not all the doors still need to be open, so most are closed.  The theater becomes so crowded that some patrons leave as they are getting a bit claustrophobic, and the doors still open can handle this. As the movie nears it’s some patrons recognize the end of the climax and leave, while the vast majority wait for the credits to roll and suddenly all are standing and wanting to leave, but only a few doors are open, so growing numbers of people must be patient and wait their turn to leave. Quickly the numbers are such that the backup prevents some from even leaving their rows and some from leaving their seats. Suddenly someone notices smoke, or even fire and there is a mad rush to get out of the theater / trade, but the only way to get everyone out fast is to open more doors, which represents the price falling. If not enough doors can be opened fast enough, many will be harmed, so more and more doors are opened, representing the price being in free fall.

Obviously, in investing, one wants to avoid the crowded trade. Sure, you can maybe make “easy” money, but only if you know to leave before the credits roll. Some recognize this before it happens, but most have to see them on the screen.

So how does this apply to us? We are constantly on the watch for the investment factors which may become “crowded” trades, specifically what our disciplined strategy is based on- relative strength.

The Big Picture recently discussed the annual Merrill Lynch survey of 100 institutional money managers. Of particular note to us are some tables that detailed what the most popular investment factors were in determining their investments.  Let there be no doubt that relative strength, amazingly, is nowhere near becoming a crowded trade. In fact, it doesn’t even make the Top Ten:

Here is the overall chart, with relative strength coming in at #11, but trailing the most popular by a large margin and in fact below 50%, which is even better news for us:

Even among the biggest changes in popularity, relative strength is quite unnoticed, again to our liking:

Suffice it to say that while will continue to benefit from an adaptive yet disciplined strategy, we are nowhere near being in a “crowded trade” or “crowded discipline” situation. And that is just fine with us.

– Eric Volk