Hedge funds are playing with fire as they all cram into the same stocks — and their behavior could make the next market crash even worse

Reuters / Vincent West

• Goldman Sachs conducts a regular survey of large investment managers, and the latest version featured findings from 880 hedge funds overseeing a gross total of $2.1 trillion in stock positions.
• The firm discovered that the "density" of hedge fund holdings is the highest since at least 2002, meaning they’re holding a big percentage of their portfolios in their top 10 stock picks.
• This is creating a dangerous situation for investors in the event of a severe market downturn — one that could worsen any major sell-off.

As an investor, it’s one thing to have conviction in your decisions. But it’s quite another to press your luck to the point where any sort of downturn can have a catastrophic impact on your portfolio.

Hedge funds are flirting with that fine line right now, according to data compiled by Goldman Sachs.

The firm analyzed the holdings of 880 hedge funds with $2.1 trillion of gross equity positions and found that a measure known as "density" is historically stretched. More specifically, Goldman found that the average hedge fund holds 70% of its long portfolio in its top 10 positions — the highest portion since at least 2002.

Goldman Sachs

But why exactly does this metric matter? Because when positions get crowded like this, it leaves investors vulnerable to sharp sell-offs.

That’s because, at the first sign of stress, investors jammed into the same holdings will simultaneously stampede towards the exits. And that, in turn, can make a bad situation worse when it comes to a major market meltdown — especially for those who get out last.

Read more: BANK OF AMERICA: 3 binary events will determine the stock market’s fate in 2019 — here are all the scenarios and what each one will mean for you

So it almost goes without saying that — in the ominous event of a full-fledged stock-market crash — the last place an investor wants to be is piled into a crowded position. To the extent that hedge funds are still loaded up on the same popular names, the next downturn could be made worse.

With all of that established, it’s worth noting that doubling down on proven winners can be a lucrative strategy when everything is going swimmingly in the market. After all, hedge funds wouldn’t be cramming into those stocks with abandon if they weren’t offering strong returns.

Still, it would seem to be a prudent strategy for investors insistent upon staying invested in crowded stocks to seek some downside hedges. At the very least, they could help offset the damage once the tables turn on those high-density trades.

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See Also:

• The market’s ‘smart money’ is flooding into industrial stocks — but one Wall Street strategist warns investors are setting themselves up for disaster
• Hedge funds were still loading up on certain stocks as the market tanked in late 2018. These are their 9 new favorites.
• GOLDMAN SACHS: This trade is your best bet for big stock gains as economic growth dwindles

SEE ALSO: Paul Krugman, Rick Rieder, and 47 more of the brightest minds on Wall Street reveal the world’s most important charts

Source: Business Insider – jciolli@businessinsider.com (Joe Ciolli)