Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Another year, another disappointing start for hedge funds.

But don’t despair -- the hedgies have a plan to lift their fortunes: U.S. small-cap stocks.

It’s been a long, long time since hedge funds outpaced the market. The HFRI Fund Weighted Composite Index lost to the S&P 500 for eight consecutive years from 2009 to 2016, and it’s on track to lose again this year. The HFRI Index is up 3.5 percent through May, while the S&P 500 is up 8.7 percent, including dividends.

It’s not just the S&P 500 that’s beating hedge funds. Astonishingly, hedge funds have trailed stocks everywhere since global markets recovered from the 2008 financial crisis. From March 2009 through May, the HFRI Index lost to the Russell 2000 Index by 11.9 percentage points annually, the MSCI EAFE Index -- a collection of companies in developed markets outside the U.S. -- by 5.6 percentage points, the MSCI EAFE small Cap Index by 10.3 percentage points, the MSCI Emerging Markets Index by 5.7 percentage points, and the MSCI Emerging Markets Small Cap Index by 8.4 percentage points.

Think about all the hardship and turmoil and disappointment that has plagued Europe, Japan and many emerging markets since the financial crisis. And still, hedge funds found a way to lose to stock markets in those regions.    

That backdrop is crucial to appreciating the latest move by hedge funds. As Bloomberg News reported last week, hedge funds have flipped their bets on U.S. small-cap stocks from bearish to bullish or, in hedge fund speak, from net short to net long. And not by a little -- it’s the biggest such swing on record since 1994.

The bullish case for U.S. small caps is dubious, however. Granted, U.S. small caps are badly lagging behind other equity asset classes in what has turned out to be a great year for global stocks. The Russell 2000 is up just 1.5 percent through May, while the MSCI All Country World Index is up 11.3 percent.

But that doesn’t mean U.S. small caps are a good value. On the contrary, they may be the most expensive stocks anywhere. The price-to-earnings ratio of the Russell 2000 is 26.7, based on 10-year trailing average positive earnings. That’s 89 percent higher than the MSCI ACWI ex US Small Cap Index -- a collection of small companies outside the U.S. It’s also 36 percent higher than the MSCI ACWI Index, which represents global large- and mid-cap stocks.  

No Bargain
U.S. small-cap stocks are among the most expensive in the world
Source: Bloomberg
Note: Based on 10-year trailing average positive earnings.

And given the slow start for U.S. small caps this year, their momentum is weaker than that of other stock markets, too. One common way to measure momentum is by looking at the ratio of current price to the 200-day moving average. The higher the ratio, the stronger the momentum, and vice versa. The Russell 2000 has a ratio of 1.05, compared with a ratio of 1.08 for the MSCI ACWI ex US Small Cap Index and 1.07 for the MSCI ACWI Index.  

So it’s hard to imagine that U.S. small caps are hedge funds’ road to redemption. It’s easier to imagine that hedge funds are tired of losing and are abandoning their calling card: the shorts.

Hedge funds have comforted themselves during this long losing streak with the thought that they will shine again when markets eventually tumble, as they inevitably do. There’s merit to that notion because hedge funds’ short positions give them some protection in declining markets. But it’s not a free lunch -- hedge funds have traditionally accepted the fact that those shorts are a drag on performance during bull markets.

The problem is that this is proving to be one stubborn bull. To borrow a Wall Street adage, markets are showing that they can remain bullish longer than hedge funds can keep their investors. One way to stop the pain is to ditch the shorts and join the bulls.

But that’s a mistake. If hedge funds fail to deliver their promised protection during the next bear market, they will have disappointed investors on the way up and down. That’s no way to regain the reverence they once enjoyed.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net