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Novus Overlap

NOVUS RESEARCHTM

RESEARCH

Novus Overlap
A better measure of diversification
By Stan Altshuller Always remember that you are absolutely unique. Just like everyone else.
Margaret Mead The predominant technique that the investment industry relies upon to calculate uniqueness in managers is fatally awed. Portfolio construction based on correlation of monthly returns has failed investors and left them searching for a better way to build diversied portfolios. Given the regulatory changes of the last few years, more data than ever are available to investors, and this data can empower them to take a dierent approach. In this paper, we propose a measure based on the portfolio holdings of managers: Novus Overlap.

Everyone is unique

Its natural for people to want to feel unique. High school students these days provide a colorful example of going to great lengths to stand out, yet when enough of them try to look dierent, they all tend to blend in, no matter how outlandish their appearances. Is a similar phenomenon occurring in the investment management world? You would be hard-pressed to nd a fund manager who tells you that his portfolio is not unique. The most commonly encountered jargon youll hear when you ask about a managers uniqueness goes something like: We play in under-followed situations or We participate in uncommon trades and one-o deals or We dont follow the crowd; we are contrarian. Certainly, we all like to think were unique, and hedge fund managers are no dierent. But how does an investor actually measure this uniqueness? More importantly, how do you as an allocator understand crowding in your portfolio of managers? Will some presumably unique manager actually add diversication to your book or increase the concentration you already have, thereby adding to overall risk? Do your existing managers add any signicant diversication benet? If you ask these questions of managers directly, they likely wont know without understanding the rest of your book, and even so, they probably consider themselves more unique than they actually are. As an investor, you need to nd the answers yourself. So, are there any tools available to investors to measure diversication, crowdedness or similarity across their hedge fund

E
Novus Overlap
How it works Overlap

NOVUS RESEARCHTM

portfolios? Absolutely. Enter the correlation matrix! Its simple to understand and has very light data requirements, requiring only historical returns. Many investors have relied upon correlation for years, and numerous software packages can help you run correlation analysis. Furthermore, you can easily create a correlation matrix yourself using spreadsheet software.

If correlation is king, the king has no clothes

If correlation analysis is so heavily relied upon in the institutional investment world, why even look at anything else? Heres a reason: It doesnt work. Correlation, as we are used to thinking about it, uses historical return streams, as do all other performance metrics ubiquitous in our industry. But making decisions based exclusively on analysis of past performance has consistently led us to disappointing results and roundly failed investors. And there are glaring issues with correlation analysis aside from being backward-looking. For example, correlation requires a statistically signicant sample of returns, is useful only for normally distributed returns, and is slow to capture style drift eects that could signicantly impact a funds current diversication benet. Another important consideration is that the factors driving correlation are not evident in the analysisin many cases, you can see high correlations, but you cant tell why they occur. In addition, a few irregular months can skew the calculation dramatically, and you could wind up with high correlation to systemic factors such as gold, for example, though you may actually have no exposure to gold in your book. Perhaps the primary reason why correlation analysis has failed investors is that correlations change. They coalesce around one, as dierent investments become perfectly correlated during severe market stress, when diversication matters most. After the

Figure 1: How it works

Portfolio A
Name BRK GOOG AAPL IBM MSFT Size 52% 30% 10% 5% 3%

Portfolio B
Name MSFT ZNGA YHOO IBM Size 48% 25% 25% 2%

Method
Minimum Average Maximum Cross A to B: B to A: Name A to B: B to A:

Value
5% 29% 53% 8% 50% 40% 50%

Calculation
IBM: 2% + MSFT: 3% IBM: 3.5% + MSFT: 25.5% IBM: 5% + MSFT: 48% IBM: 5% + MSFT: 3% IBM: 2% + MSFT: 48% Common: 2 / Total: 5 Common: 2 / Total: 4

Notes
Sum of the smaller of two weights for each portfolio Sum of average of the weights of common names in both portfolios Sum of the larger of two weights for each portfolio Sum of the weights of portfolio A in common names Sum of the weights of portfolio B in common names Total number of common names divided by total names in portfolio A Total number of common names divided by total names in portfolio B

Novus Overlap

NOVUS RESEARCHTM

nancial crisis in 2008, we observed a rather disturbing correlation matrix of investments that had looked perfectly ne prior to the volatility spike. In other words, past and future correlations are inconsistent. This problem has left investors searching for a better way to measure and identify crowdedness, herding, similarity, and, most of all, their sought-after antithesis, uniqueness. The good news is that a better way to measure uniqueness exists; the bad news: it will take some work on both the data and analytics fronts. To measure risk from crowding, investors must use underlying portfolio positions. The benet of looking at holdings is simple: If two managers have a large position in Facebook today and the stock moves, they will both be aected. Historical correlations simply do not have such predictive power; Facebook was not around two years ago and did not contribute to returns relied upon by correlation analysis. So how do investors get their hands on manager holdings? A recent study shows that over 20% of all managers report positions to their investors. Where private positions are not available, investors can lean on the abundance of publicly disclosed holdings data, a dataset that is growing rapidly due to the post-2008 increase in regulatory requirements from governments around the globe. Once the data are gathered, you need to do something with them. Our clients are looking beyond correlation and adopting the Novus Overlap metrics to make more robust inferences about the true diversication of their portfolios.

What is overlap, and how is it calculated?

Overlap analysis provides insight into how a portfolio of managers may behave in the future based on similarities in their underlying holdings, their participation in crowded situations and the relative uniqueness of each manager in the context of the portfolio (or group) to which they belong. Like correlation, overlap is a measure between two funds. But unlike correlation, overlap is based on the positions in which those funds are invested and the corresponding weights in positions common to both funds. We focus on ve kinds of overlap calculations and will draw on simple examples to illustrate the math. Its rather straightforward once you have the data organized. The ve main varieties of overlap are: Minimum, Maximum, Average, Cross and Name. Figure 1 on page 2 illustrates how dierent overlap measures are calculated for two distinct portfolios. Overlap is concerned only with common positions; the rest of the portfolio is not considered. (Here comes some mathhang in there!) Minimum overlap tallies up the smaller of the weights for each common position between two portfolios. In gure 1, you see that if two portfolios both hold IBM and MSFT, minimum overlap takes the smaller of the two weights for each matching pair and sums them up. You can just as readily tally the larger of the two weights (maximum overlap) or take the average of the two weights (average overlap), but we nd these variations to be less telling. You might say that minimum overlap is the most understated measure because it shows the minimum portion of the portfolio that is identical between two managers. In this calculation, you will always have the same overlap measure for two managers (the overlap of Manager

Figure 2: Overlap matrix (minimum)

Minimum Overlap (%)

Manager 1 Manager 2 Manager 3 Manager 4 Manager 5 Manager 6 Manager 7 Manager 8 Manager 9 Manager 10 S&P 1500 Average 23 2 21 0 11 18 21 19 12 7 14 2 28 0 8 21 16 14 10 7 14 4 0 4 0 1 0 7 3 2 0 4 20 13 15 6 7 12 0 0 0 3 0 1 0 4 8 0 5 4 5 13 17 9 4 11 14 6 4 10 13 8 11 7 8 5

S&P 1500

Q3 2013

Manager 10

Manager 6

Manager 9

Manager 4

Manager 8

Manager 7

Manager 3

Manager 2

Manager 5

Manager 1

Novus Overlap

NOVUS RESEARCHTM U.S. long/short equity managers mostly focused on a fundamental value-based strategy. First, we will look at the minimum overlap matrix (gure 2). Instantly, we can spot some similarity between managers. For instance, Managers 2 and 4 share at least 28% of their portfolios. This means that about one-third of these managers books will behave absolutely the same, no matter what the markets bring. We can also observe evidence of uniqueness, as Manager 5 hardly overlaps with anyone else. We can also quickly see that Managers 1, 2 and perhaps 4 and 7 bring little diversication benet to this group. If we want to allocate capital to one of these managers, we should do some additional work. So lets convert this to a cross overlap matrix and dive a bit deeper. The cross overlap matrix (gure 3) reveals further compelling evidence of crowding and uncovers detail obscured in the minimum numbers. Now Managers 4, 7 and 8 look worrisome, as large portions of their portfolios are owned by other managers in this group. In the case of Manager 7, only 19% (1.0 minus 81% overlap to S&P 1500) of his portfolio by assets is invested outside the S&P 1500. Can that portion alone justify the two-and-twenty fees charged on the whole book? (It might, but further work needs to be done to understand how.) Lets look again at Manager 5, who had very low overlap numbers compared to other managers. We see that Manager 5 has 26% overlap to Manager 9 and 48% to the benchmark, while other numbers seem very low. We can hypothesize that Manager 5 shares some names with Manager 9, and that Manager 5 has fairly large allocations to those names, while Manager 9 has small allocations to the same names.

A to Manager B is equal to Manager Bs overlap to Manager A). In other words, minimum, maximum and average overlap are commutative. Cross overlap, on the other hand, will yield two dierent numbers depending on the order. This measure sums up the actual weights of each portfolio invested in the common names. Thus, if Manager B has higher allocations to common securities than Manager A, then Manager B will have the higher overlap measure. This makes sense when Manager A runs a very large fund that can move names if it sells them. You want to understand what portion of Bs portfolio is at risk of As liquidation. So, using the above example, Manager A has only 8% of its portfolio in stocks owned by B, whereas Manager B has 50% of its names common to Manager A. If Manager A liquidates, Manager B will be aected in 50% of its portfolio, possibly to the tune of a few percentage points in each aected name. Finally, name overlap ignores weights altogether and looks at only the number of names that are identical. In other words, its a special case of cross overlapthat of equally weighted portfolios. Now that you have your overlap measures calculated for all your managers pair combinations, how do you visualize them?

Novus Overlap Matrix

Looking at a portfolio in a matrix format is not foreign to investors thanks to good old correlation. But now that we have a better measure of similarity, the overlap matrix will have you looking into the future rather than the rear-view mirror. The following set of overlap matrices are based on 10 actual public portfolios of active managers. Lets just say that these are large, well-known

Figure 3: Overlap matrix (cross)

Cross overlap (%)

Manager 6

Manager 9

Manager 4

Manager 8

Manager 7

Manager 3

Manager 2

Manager 5

Manager 1

S&P 1500

Q3 2013

Manager 10

Relative uniqueness 21 25 55 17 72 61 30 34 36 47 34 40

Manager 1 Manager 2 Manager 3 Manager 4 Manager 5 Manager 6 Manager 7 Manager 8 Manager 9 Manager 10 S&P 1500 Average 35 3 44 0 23 34 49 32 16 7 17

24 2 48 0 15 28 30 23 11 7 19

2 4 6 0 6 0 5 0 9 3 6

23 35 19 0 5 32 27 19 7 8 22

0 0 0 0 0 0 0 3 0 1 3

12 13 4 7 0 6 9 0 7 4 9

18 22 0 20 0 4 21 17 11 4 19

22 22 1 20 0 11 13 16 7 4 21

29 24 6 37 26 0 38 27

19 18 23 20 0 16 20 22 29

53 57 61 72 48 40 81 57 80 73

19 9 15 7 10

Novus Overlap

NOVUS RESEARCHTM group. Its the sum of all weights in positions not common to anyone else in the portfolio. Studying uniqueness numbers (gure 2) helps substantiate our thesis that Managers 2, 4, 7 and 8 do not bring much diversication to the table. But we also realize that Manager 4 has 83% of its book already represented in this portfolio (1.0 minus 17% uniqueness). Wouldnt that be nice to know if you are thinking of adding them to your lineup? The most unique managers are Manager 5 and Manager 6, both possessing over 60% of holdings unique to this group. Crowdedness of a portfolio can be estimated by the average overlap of all funds in that portfolio. Heres some context: If you choose two managers at random from a group of 3,000 public portfolios, your expected overlap for the pair will be 4%. In our sample portfolio of funds, the number is much higher (17% for cross overlap), which isnt surprising considering that we didnt choose managers at random but from a pre-dened group of large long/short equity, fundamental value investors. To understand a single managers crowdedness, however, we must compare them to a portfolio of crowded trades. We can construct such a portfolio based on the number of hedge funds (in the whole industry) that participate in the name and the percent of average daily volume they hold. After the portfolio is constructed, we can run cross overlap of each manager against the crowded portfolio to understand the portion of its book exposed to crowded trades.

Looking at overlap by name (gure 4), Manager 7 again stands out in not adding signicant diversication. Over 80% of its names are from the S&P 1500, and it shares one-third of its names with four other managers in this group. Returning to Manager 5, we see that only 3% of its names are identical to Manager 9 (which accounts for 26% of its book, judging from cross overlap), indicating that the overlap is concentrated in very few names, probably one or two. To nd out whats contributing to overlap, we can view the data behind the matrix in a table, listing the most popular names rst, as well as each managers respective allocation to these names. In gure 6, we see that the securities that overlap the most have a large number of managers invested in size. Interestingly, Managers 2, 4 and 7 are invested in four of the most popular securities. Manager 5 has a 26% allocation to Security 29, and Manager 9 has 3% in the name, explaining the skewed overlap numbers.

Using overlap to calculate uniqueness and crowdedness

Now that we have a framework for calculating and visualizing overlap, we can apply the same construct to understand the relative uniqueness of a manager in a portfolio. To get at uniqueness, simply calculate the cross overlap of the manager to the aggregated portfolio of all other managers taken together, and then subtract that number from 1. Whats left is the portion of the managers portfolio that is unique to them in the context of the

Figure 4: Overlap matrix (name)

Name overlap (%)

Manager 6

Manager 9

Manager 4

Manager 8

Manager 7

Manager 3

Manager 2

Manager 5

Manager 1

Manager 1 Manager 2 Manager 3 Manager 4 Manager 5 Manager 6 Manager 7 Manager 8 Manager 9 Manager 10 S&P 1500 Average 23 5 25 0 13 35 24 23 11 2 12

17 3 31 3 10 27 18 17 8 2 14

3 2 4 0 4 0 2 2 7 1 5

18 30 5 0 6 31 14 17 6 2 14

0 2 0 0 0 0 0 2 0 0 1

10 9 5 6 0 8 8 0 6 1 6

13 13 0 16 0 4 6 13 6 1 18

17 17 3 14 0 8 12 12 7 1 11

19 19 3 20 3 0 31 14

14 13 16 10 0 10 19 12 20

13 3 12 4 7

S&P 1500 39 47 41 61 17 37 81 34 73 67 2

Q3 2013

Manager 10

Novus Overlap

NOVUS RESEARCHTM of the industry as a whole. But as we think about overlap or any other similarity measures, we should keep in mind that behind the numbers are people making decisions, picking stocks, adhering to their investment process. Surely if overlap exists, there must be leaders and followers. Who entered that particular trade rst? Why did others follow? Maybe copycat behavior causes overlap, or perhaps its the concept of great minds think alike, as managers processes converge on the same great ideas. Likely its a bit of both. Even if there is copycat behavior in similar funds, is overlap all that bad? The managers selected here are all highly successful investors hailed as thought leaders. Consensus vs. crowdedness still requires more analysis before one can make a rm statement on what is good for the markets in general. But when it comes to allocators portfolios, one should be aware of the risks and benets that each manager adds to the lineup. Overlap will most likely gain attention as more and better data become available to investors and the technology catches up. Until that happens, investors will have to settle for crunching correlations and taking managers at their word when they claim to be unique.

Historical uniqueness: Show me the trend

Knowing that you weigh 190 pounds is great, but are you down from 210 or up from 170 a year ago? Trends are much more telling than snapshots. Like a portfolios style, valuations and performance, overlap evolves and changes with time. Tracking uniqueness and crowdedness (gure 5) through time can be fascinating on a manager-by-manager basis. Scrutinizing the trends, we can see that while Manager 1 is not very unique, the situation is improving recently, while Manager 4 has been getting less unique with time.

Conclusions and thoughts for future analysis

We are currently developing new ways of calculating overlap, especially as it relates to the crowdedness and concentration

Figure 5: Historical Uniqueness

Q1/10 Q3/10 Q1/11 Q3/11 Q1/12 Q3/12 Q1/13 Q3/13
20% 21% 14%

Manager 1

35%

Manager 2

21%

44% 16%

25%

Manager 3

60% 66% 25% 55% 49%

55%

Manager 4

17% 17% 72% 85% 42%

Manager 5

72%

Manager 6

56% 76% 45% 32%

61%

Manager 7

30% 44% 15% 34%

Manager 8

21% 21% 42% 62% 31% 50%

Manager 9

36%

Manager 10

50% 63% 45%

47%

Novus Overlap

NOVUS RESEARCHTM

Figure 6: Positions
Positions (%)

Manager 10

Manager 4

Manager 9

Manager 8

Manager 6

Manager 7

Manager 2

Manager 5

Manager 3

Manager 1

Q3 2013

Equity Security 1 Security 2 Security 3 Security 4 Security 5 Security 6 Security 7 Security 8 Security 9 Security 10 Security 11 Security 12 Security 13 Security 14 Security 15 Security 16 Security 17 Security 18 Security 19 Security 20 Security 21 Security 22 Security 23 Security 24 Security 25 Security 26 Security 27 Security 28 Security 29 Security 30 Security 31 Security 32 Security 33 Security 34 Security 35
1.5 3.9 3.2 3.5 1.4 2.0 3.4 2.4 4.7 6.1 1.5 8.4 5.2 2.2 0.7 0.0 0.1 0.7 3.5 0.2 0.5 26.3 2.6 0.9 1.3 3.4 4.4 3.3 2.2 0.0 0.3 3.5 0.4 1.1 0.1 0.1 0.1 2.0 1.0 1.8 2.8 1.0 5.5 1.8 2.1 0.6 1.5 0.9 5.4 0.1 2.4 2.1 0.1 0.6 0.1 0.1 3.9 1.5 4.2 3.6 2.7 3.7 1.0 1.5 0.4 2.0 2.3 8.1 2.3 2.3 3.8 1.5 9.5 6.4 3.6 3.7 4.7 1.4 1.2 1.0 3.4 1.2 17.7 2.1 3.3 5.5 2.5 1.2 1.1 0.8 1.7 4.1 0.2 0.3 3.8 2.4 0.9 1.6 2.9 4.2 4.8 3.2 4.0 2.8 1.1 3.5 3.8 2.4 3.4 1.1 4.6 0.6 2.1 3.5 0.5 2.5 0.3 1.3 3.9 2.5 0.0 3.7 8.0 5.5 1.8 4.5 3.3 3.3 5.0 8.8 5.2 5.2 1.0 2.6 8.2 3.6 4.4 0.3 0.8 0.4 0.3 0.3 0.2 1.4

S&P 1500

Novus Overlap

NOVUS RESEARCHTM

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FOR MORE INFORMATION, CONTACT Stanley Altshuller Chief Research Ocer stan@novus.com

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