It’s been no secret that most hedge funds have underperformed compared to the S&P 500, and data on the most popular hedge fund positions based on 13F data shows why. Most of the hedge fund’s favorite stocks have underperformed, causing fund managers to generate lower returns than the overall market.
Because of this, investors who followed the so-called “smart money” may have seen their stocks fall. Although a two-month relief rally suggested that hedge fund favorites were turning around, returning to their usual position of outperformance, the last two weeks of August brought another change.
In fact, there was one sector in particular that hedge funds dumped in the second quarter that may not have been a smart move – the energy sector. Meanwhile, they are again buying sectors such as information technology. They appear to be pivoting from value to growth, which I think is a premature decision.
Are hedge funds reversing course?
In their latest “Hedge Fund Trend Monitor,” Goldman Sachs (GS, (financial analysts) reported that the average equity hedge fund was down 9% year-to-date at press time due to weakness in the hedge funds’ most popular stocks and a beta headwind caused by the tanking S&P 500 .Goldman reported that its basket of the most popular hedge fund longs is down 22% year to date, compared to the 10% decline generated by the S&P 500 over that period.
Recently, the firm has begun to see moderate efficiency in its most popular positions, but new evidence suggests they may be reversing course, at least for now.
According to Goldman, the S&P 500 hit a low on June 16, and through mid-August, its basket of the most popular hedge fund stocks slightly outperformed the index, returning 18% compared to 16% of S&P. In fact, the average equity hedge fund has returned 4% over the past two months, suggesting the potential for a turnaround.
However, since the latest “Hedge Fund Trend Monitor” was released on August 23, the S&P 500 has started to decline again. Long-term interest rates, as measured by the yield on 10-year Treasuries, have fallen sharply, but recently, rates have started to rise again.
The most important ‘if’
This suggests that the bull market that so many analysts were quick to call may have broken after just two months. Of course, Goldman Sachs analysts are quick to point out that the outperformance of the most popular hedge fund stocks is consistent with typical patterns around past drawdown troughs in the equity market.
They looked at the five previous corrections of at least 10% in the S&P 500 since 2011 and found that the performance of popular hedge fund stocks typically changes around the time of a market trough, which is what happened around the recent low. S&P in mid-June. . In those episodes, Goldman’s “Hedge Fund VIPs” (very important positions) continued to pass quietly for the next few months after the trough.
Thus, Goldman analysts suggested that the pattern could mean further increases in hedge fund favorites throughout the rest of this year – “if the equity market remains stable or continues to climb, although it remains clear which are downside risks.”
That “if” turned out to be critical, as the S&P 500 appeared to peak in mid-August at around 4,305. Since then, the index fell to around 4,129 on Aug. 23, the date of Goldman’s “Hedge Fund Trend Monitor,” and then fell further to 3,980 on Aug. 31.
Warnings on following the ‘smart money’
It can be important for investors to track the stocks most hedge funds buy, even if they don’t plan to follow suit. After all, Goldman’s “Hedge Fund VIPs” have outperformed the S&P 500 in 59% of the quarters since 2001. However, the basket has been less profitable recently than usual, as it has underperformed the index year to date with a 22% loss compared to the index’s 10% loss.
Additionally, investors should be aware that even when hedge fund VIPs outperform, it comes at the cost of extreme volatility. Between early 2021 and June 2022, the basket sustained its worst-ever underperformance, lagging the S&P 500 by 28 percentage points.
In the second quarter, hedge funds generally pivoted from growth to value, reversing the trend observed for much of the past two years. The rotation can be seen in both sector-neutral factors and through sector rotations. For example, hedge funds sell energy and materials stocks while acquiring information technology and consumer discretionary shares.
However, despite the increased bias toward growth, hedge funds remain more value-biased and less growth-biased than they have been over the past few years.
The most popular hedge fund is long
At the end of the second quarter, hedge funds were the most exposed to information technology at 21%, although the sector was also their largest underweight at -458 basis points. Meanwhile, industrials took up just 14% of hedge funds’ exposure, although the sector was also their biggest overweight at 559 basis points relative to the Russell 3000.
Additionally, hedge funds are reducing their exposure to communications services and now have the smallest net tilt in the sector in the last 10 years. They also threw energy in the second quarter.
According to Goldman, the top 10 stocks that appear most frequently in the top 10 hedge fund holdings are now Amazon (AMZN, Financial), Microsoft (MSFT, Financial), Alphabet (GOOG)(GOOGLE, Financial), Meta Platform (META, Financial), Visa (v), Apple (AAPL, Financial), Uber Technologies (UBER, Financial), Mastercard (M.A, Financial), Berkshire Hathaway (BRK.A, Finance)(BRK.B, Financial) and ServiceNow (NOW, financial).
Unfortunately, all of those stocks are in the red year to date. Berkshire Hathaway was the only one in the green at the time of the report, but as of this writing it’s down about 6%, with all of that decline coming in the last two weeks.
Additionally, while the top 10 stocks primarily recorded large, double-digit negative returns on August 18, they fell further to close the month. Amazon is now down 25% year to date, while Microsoft is down 21%, and Alphabet is down 24% year to date.
Rising and falling stars
Next, let’s look at the performance of the stocks that have had the biggest rise in popularity among hedge funds. Over the past two decades, stocks with the largest increases in the number of hedge funds holding them have typically outperformed their sector peers in subsequent quarters, according to Goldman Sachs.
The top 10 stocks with the biggest gains among hedge funds holding them over the past two decades are Switch (SWCH, Financial), Chevron (CVX, Financial), Tyler Technologies (TYL, Financial), Nucor (NUE, Financial), Berkshire Hathaway, FedEx (FDX, Financial), NCR (NCR, Financial), Boston Properties (BXP, Financial), State Street (STT, Financial) and Marathon Petroleum (MPC, financial).
Unfortunately, we’re seeing mixed results with this strategy in 2022. The rising stars highlighted in Goldman’s May “Hedge Fund Trend Monitor” have outperformed the falling stars from the same report. However, rising stars have underperformed the Russell 1000 since then.
Despite their underperformance compared to the Russell 1000, the rising stars outperformed the “Hedge Fund VIPs.” For example, Switch is up more than 20% year to date, while Chevron has gained 34%. Nucor is up 19%, and Marathon Petroleum has gained 55% year to date.
In fact, I believe there is an important lesson to be learned from the latest hedge fund trends. Hedge funds began shedding energy in the second quarter, reducing their positions in the sector by 279 basis points. However, many stocks in the sector, including Marathon and other rising stars, are still high to date. This suggests that the hedge fund’s move toward regrowth may be premature.