Hedge Funds Trailing Stock Rally May Be S&P 500’s Next Big Buyer

  • Persistent equity rally could force hedge funds into stocks
  • Bank of America: hedge funds reduce longs most in five years

Didn’t think this year could get any worse for hedge fund managers? Guess again.

As if posting their worst start to a year and suffering the biggest crush of outflows since the financial crisis wasn’t enough, hedge fund managers are now watching the S&P 500 Index close in on its record at a time when they’ve been unloading stocks.

As a class, the speculators reduced bets on equities by 8.7 percent going into the second quarter, the biggest retreat from the stock market in five years, according to Bank of America Corp. At the same time, they added short positions -- a call that remains profitable on the year but is losing steam as more companies join the three-week rally in shares.

“After a very tough first quarter, a lot of risk management kicked in and hedge funds pulled back on longs,” Nicholas Colas, chief market strategist at Convergex Group LLC, said by phone. “If you don’t reinvest into something less crowded, you’re left too hedged and not long enough. It’ll be interesting to see how those money flows work out in the next few weeks because there’s time for an underperforming fund to put money to work.”

Managers are trailing the benchmark equity gauge by the most at any point this year, with a Hedge Fund Research index of equity funds lagging behind the S&P 500’s 3.7 percent gain by 5.3 percentage points through Monday this year. The index closed Wednesday at 2,119.12, about 0.6 percent from an all-time high.

To be sure, hedge funds did their job in the first two months of the year, and if it weren’t for the quality of their short picks that paid off in the first quarter, the situation would be even more dire. Bearish bets are still working -- so far this quarter, those companies are trailing the S&P 500 by almost 5 percent, according to the Bank of America report.

Still, while hedge funds handily beat the S&P 500 during its 11 percent rout at the start of 2016, their performance is worsening the longer the equity rebound continues.

A sustained rally in U.S. equities would mean a second chance for active investors that largely missed out on the 16 percent rebound after the S&P 500 bottomed in February. That time around, mutual funds hoarded cash, short sellers upped their bearish positions, and retail investors fled the equity market -- all while hedge funds were short S&P 500 futures.

All that may be good news for the stock market. With just three weeks left in the second quarter, money managers lagging behind the benchmark index will feel pressure to buy stocks to get performance in line with the S&P 500 before the end of the quarter, according to Neil Azous, founder of Rareview Macro LLC.

Going into the second quarter, hedge funds owned a smaller percentage of stocks in the Russell 3000 Index -- 5.4 percent of available shares -- than at any time the past three years, according to the Bank of America report. Net positioning fell to 61 percent from 73 percent, the study shows.

“All these hedge funds have brought their gross exposure down and if we go up to new highs, they’ll be forced to put exposure back on,” Stamford, Connecticut-based Azous said by phone. “The pain is acute. The only way mathematically these long-short funds can catch up to the S&P index is if the stock market crashes -- if it goes up they’ll have to buy with more leverage or turn their portfolio upside-down.”

One question is what stocks they’d buy. According to an Evercore ISI analysis in May of 13F filings with the Securities and Exchange Commission, hedge fund managers doubled down on the same strategy that was at the heart of market turbulence in the beginning of the year: momentum stocks, or those that have had the best returns over a set time period.

Not only are they sticking with the strategy, they’re diving in with greater conviction. Research from Goldman Sachs Group Inc. this month showed hedge fund managers have a greater portion of their assets in their top 10 holdings that any point on record.

That said, the universe of stocks classified under the umbrella of “momentum” shares changes over time. In the past 12 months, utilities, consumer staples and telephone stocks have led the market, and are still some of the biggest winners year-to-date, all gaining more than the S&P 500.

Those aren’t exactly traditional favorites of hedge fund managers, says Convergex’s Colas. That may explain why, according to Bank of America, they increased holdings in discretionary, technology and staples stocks more than any other industry groups going into the second quarter. So far this quarter, those groups are lagging behind the top five sectors in the S&P 500.

“We’ve seen GDP growth slow and inflation slow and some of these higher growth companies are no longer potentially suitable at this point,” Stewart Warther, an equity and derivatives strategist at BNP Paribas SA in New York, said by phone. “There’s less certainty about which styles are likely to perform and that’s resulted in an unwinding of positions resulting in a cut to long positions.”

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