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Hedge funds hedge. It’s right there in the name. Their value to investors, generally speaking, is not to beat the market but to offer uncorrelated returns. And because stocks go up more often than they go down, “uncorrelated with” for equity long/short funds tends to mean “less than”.
That’s been particularly true recently, because it’s tough to trade smart in a global market that’s powered by just seven stocks. Whatever the strategy employed, overarching mandates of risk management and loss protection mean being underweight the winners so underperformance versus equity benchmarks is pretty much guaranteed.
The underperformance has narrowed a bit recently, however. See if you can you can spot why:
Portfolios ended 2023 with “a record tilt toward momentum” and “the largest tilt towards growth since 2016”, says Goldman Sachs in its latest hedge fund tracker. Position crowding is now at “exceptional” levels and points to “a violent unwind if the market environment shifts, as briefly occurred during the last several weeks of 2023”:
Goldman pulls data from 722 hedge funds whose gross equity positions total $2.6tn. Among its checks is to look for the most popular long positions of fundamentals-driven funds, which it offers to clients as “a tool for investors seeking to follow ‘the smart money’”.
Lately, though, ‘the smart money’ has been trying to catch up with investors. Energy and materials sectors barely feature on its hit list. Real estate and utilities are ignored completely. Tech, meanwhile, is 22 per cent of the total with all but one of the Mag7 filling the top spots.
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That’s all in spite of hedge funds being net sellers of mega-caps over the fourth quarter. Their concentration problem has remained because the value of the Mag7 rose faster than they were selling:
And it looks like at least some of the banked from taking profit in one Mag7 has been reinvested in buying another Mag7:
… Which is perhaps a symptom of malaise among the small-caps. A traditional source of long-short alpha, small has been looking increasingly correlated with large:
Another trend is that long-short doesn’t seem to involve much short. “The median S&P 500 stock carries short interest equal to 1.7 per cent of market cap, well below the average of 2.2 per cent since 1995. Single stock short interest remains below average across every S&P 500 sector,” Goldman writes:
As for Goldman’s list of the most heavily shorted stocks, the less-than-magnificent one is way out in front:
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Last year the MSCI All Country World Index rose 20 per cent and the HFRI Fund Weighted Composite index was up 8.1 per cent. Year-to-date things are looking only slightly better, with US equity long/short hedge funds trailing the S&P 500’s continued surge by about one percentage point.
That’s all fine. Plunge protection comes with a performance penalty. Less fine would be if an industry that’s been haemorrhaging funds in an absurdly top-heavy market tried to remain relevant by index hugging, because that’s not plunge protection, it’s the opposite.
Further reading:
— Do hedge funds work? (Thought Economics)
