How To Beat The Market: One Surprisingly Simple Trade
Tyler Durden

Back in 2012 and then again in 2013, after repeatedly observing just how broken markets have become as a result of central bank intervention, a topic that back then was still taboo and is now wholeheartedly accepted even by the Davos billionaires (whose mood the WSJ summarized as "irritated, bordering on affronted, with what they say has been central-bank intervention that has gone on too long") we presented what may have been the "best alpha opportunity around" and how to outperform the "market" in a world in which not only fundamentals no longer matter, but in which hedge fund herding has led to relentless losses for the active investor community for 7 years in a row as a result of the omnipresence of central banks who have made hedging pointless: just do the opposite of what everyone is doing, and go long the most shorted stocks.

From our September 2013 post:

In a world in which nothing has changed from a year ago, and where fundamentals still don't matter, what is one to do to generate an outside market return? Simple: more of the same and punish those who still believe in an efficient, capital-allocating marketplace and keep bidding up the most shorted names.

As we documented both before and since, this trade has continued to generate alpha even as the smartest people in the room sat down during long idea dinners and scrambled to come up with ways to justify their 2 and 20 (and in the case of Bill Ackman last week, blamed precisely the same idea dinners for their underperformance).

Today, none other than Bank of America's chief equity quant Savita Subramanian throws in the towel and admits that the best trade over the past several years has been precisely what we first suggested in 2012: do the opposite of what the crowd does. To wit:

We continue to urge investors to watch positioning: over the last several years, during which active inflows were weak to negative but passive inflows were heavy, the strategy of buying the 10 most underweight stocks and selling the 10 most overweight stocks at the beginning of each year has outperformed; this simple trade has produced alpha in excess of the typical long-short equity hedge fund.

Indeed... and while BofA won't go so far as to admit going long the most hated names leads to even higher alpha, the principle is the same: since fundamentals don't matter, and since cash flow remains (or remained until the recent tremors in the energy space) irrelvant, the only catalyst is to wait and watch as grouped positioning unwinds.

Here is more from Bank of America:

Over the last several years, with outflows from active funds into passive funds, buying the most underweight stocks has been a source of alpha, and so far this year has generated over 5ppt alpha.

While clearly late to the party, BofA believes the trade will still work:

Why positioning will likely continue to drive alpha

Flows out of active into passive have been extreme for the last several years, suggesting to some that the rotation may be close to over. Unfortunately, we think there is more to come. After the last few years of declining alpha from active funds coupled with strong years for the benchmark, outflows from active to passive have accelerated. And close to 70% of large cap AUM still resides in active funds, suggesting we are likely far from critical mass in passive. Moreover, regardless of flows, crowded stocks have chronically underperformed – stocks that are 3x or greater than the benchmark weight have underperformed by 12ppt ann. based on data back to 2008.

So as our relatively under the radar idea that has resulted in substantial alpha for those who put it on becomes mainstream, here is BofA with its listing of the most concentrated stocks:

We highlight the top 5 stocks within each sector by concentrated ownership. We assess concentrated ownership by two measures:

1. Percentage of shares held by the top 10 holders; and
2. The Herfindahl measure of concentration index (the sum of the squares of the percentage holdings of each individual fund).

Stocks that are rated UNDERPERFORM are highlighted as having particularly high sell-off risk.

Here is the full list:

Finally, putting all this together, this is what BofA believes is the "trade for today" based on its proprietary index of most overweight (sell) and most underweight (buy) stocks among the active investor community.

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We conclude with one big caveat: this strategy only works as long as the market is broken and as long as central banks, such as the BOJ and its NIRP stunner on Friday, remain the predominant "activists" in the market. However, if and when normality returns, if fundamentals once again matter, if the Fed and its central bank peers won't inject trillions in liquidity every time there is a 10% correction or push global bond yields to record lows, the trade will lose.

However, we are confident that even the most P&L-focused managers will be eager to part with a few basis points if it means that the market may finally return to its former rational self, one where picking winners and selling losers is what it is all about, and not this farce where the only thing that matters is which central banks will inject liquidity or how much in capital outflows will any given emerging market soak up this month to cover losses from waning commodity export revenues.

For now, we are hardly in danger of entering the Untwilight Zone any time soon.

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