What's Our View on Crowded Trades?
A crowded trade is defined as a trade whereby the market participants have large, concentrated, and similar positions, leading to the risk that there may be insufficient liquidity should investors seek to unwind their positions simultaneously. Crowded trades are often the blame in a market crisis, when panic selling kicks in. Below is our thinking on this subject.
(1) A crowded trade does not always equal to the wrong trade. Today, crowded trades seem to be occurring globally in both the U.S. and China markets. Until recently, certain “crowded trades” continued to outperform the market and deliver superior risk-adjusted returns. Crowded trades are neither good or bad in our view. Being a crowded trade alone does not justify whether we should or should not invest in the stock.
(2) Our exposure to crowded trades is not static but changes over time. In fact, as value-based, contrarian investors in China, we often had minimal exposure to momentum-driven, crowded trades historically. It’s just that today, the market happens to favor some of the our core holdings of value stocks, resulting in above-average exposure to the crowded trades.
(3) Regardless of the market environment, our investment decision is first and foremost driven by our investment philosophy, strategy and process, with strong disciplines in place. Our current exposure to crowded trades is purely incidental, not because we are seeking momentum or following the crowd.
(4) Though our buy/sell decisions are independent of the “crowd”, we need to proactively manage the liquidity risk of unwinding all positions, including but not limited to the crowded trades. We view liquidity as one of the top risk factors this year. And we are improving our risk management system to better cope with unexpected changes in the trading liquidity. While it is difficult – it not impossible – to predict when wide-spread selling will occur next, limiting the position size of crowded trades can help us mitigate the related liquidity risk.
(5) The recent volatility spike in some of our core holdings suggests there may be some momentum-driven, low-conviction, fast money behind these stocks, the so-called “weak hand” that are selling voluntarily or involuntarily. The China A-share market is traditionally dominated by such retail or retail-like investors, which we cannot change or avoid. However, we also note that the investor structure of the A-share market is changing, with increasing participation by institutional and global investors. These investors may also participate in crowded trades but they buy these stocks for the right reason, i.e. long-term investment with relatively high conviction. We believe the rising percentage of institutional and global investors are positive for this market, and can offset the negative impact from crowd-selling.