One can argue that few industries have “suffered” more under central planning than billionaire hedge fund managers, and as 2016 goes on, so does the suffering continued.
It is no secret to regular readers that over the past decade, hedge funds have not only underperformed the market, but have failed to generate “alpha” since 2011.
As we have shown year after year, the centrally-planned “New Paranormal” has been a disaster for traditional alpha generation, since with all traditional fundamental relationships flipped upside down thanks to the Fed, the only way to generate outsized returns for one’s investors (and one’s offshore bank account) was to be massively levered beta, or merely wrong.
Sadly for the 2 and 20 crowd, in the third quarter this troubling trend continued, with Goldman’s latest Hedge Fund Trend Monitor reporting that in te first 9 months of 2016, the hedge fund industry generated a mere 4% return, underperforming the broader market’s 9% YTD return and as Goldman notes, “on pace to lag the S&P 500 for the eighth straight year”
Compared to last quarter’s update, when we showed hedge funds returning only 3%, implies that in Q3 the Hedge Fund industry added a grand total of 1% in P&L.
Worse, the average macro fund returned a negative 1% YTD, and just as curious, the index of 50 most shorted companies continues to outperform the 50 most popular names YTD, +8% vs +7%, suggesting many hedge funds continue to be squeezed on popular bearish bets.
Another observation: “hedge funds and mutual funds both entered 4Q 2016 with large overweights in Info Tech stocks, which outperformed S&P 500 by 650 bp through October, but have lagged by 300 bp in the past week as funds reallocated post-election.” Which likely explains the recent underperformance of tech names, which were offloaded by hedge funds as a result of a dramatic sector rotation by the “smart money” into industrial and bank shares.
Based on 13F filings, at the start of 4Q 2016, hedge funds held a net weight of 24% in the Info Tech sector, their largest net allocation to the sector in over a decade. Tech stocks similarly make up 30% of our Hedge Fund VIP basket. After outperforming the S&P 500 by nearly 11 percentage points from July through October (+13% vs. +2%), Tech stocks have lagged by more than 300 bp this month as investors rotated to other opportunities post-election, suggesting that many hedge funds were again slammed in the violent rotation out of tech names. This, according to Goldman, means that “the latest hedge fund and mutual fund filings highlight Info Tech stocks as particularly vulnerable in terms of positioning.”
Sure enough, as the WSJ observes, “tech stocks — the biggest winners from July through September — have run out steam over the past two weeks. The group had gained just 0.7% from the election through Monday, compared with 2.7% for the S&P 500. Financial stocks have climbed 11%, led by banks, and industrial ones are up 5.6%.”
What was the catalyst for the dramatic sector rotations? Why Donald Trump, who caught a record number of hedge funds on the wrong foot, and who were forced to scramble out of tech (and duration/dividend) into anything inflation-related: “tech stocks have lagged by more than 300 bp this month as investors rotated to other opportunities post-election. At the same time, large allocations to the Health Care and Financials sectors, particularly among their largest and most popular positions, have helped offset the damage from lagging Tech stocks. The Health Care and Financials sectors rank as the third and fourth largest net weights in the aggregate hedge fund equity portfolio (17% and 11%). Together the sectors account for 28% of the VIP basket. The combination of rising rates and improved regulatory outlooks has boosted the sectors post-election.“
Another driver of potential outperformance: repatriated cash which would be used to buyback shares:
Although their foreign exposure has been a headwind to recent performance, an opportunity to repatriate overseas cash at a low tax rate could benefit some of the most popular hedge fund long positions. Nine of the basket’s constituents rank among the top 50 S&P 500 companies based on dollar value of earnings permanently reinvested overseas (ticker: GSTHSEAS), including two of the top three companies (MSFT and AAPL). A tax on previously untaxed foreign earnings has been proposed by both House Republicans and President-elect Trump and, if passed, could affect the performance of stocks with large overseas cash balances – as would potential changes in tax treatment of future foreign revenues that House Republicans and President-elect Trump have also proposed.
Still, in light of the post-election repositioning fireworks, what we find remarkable is that despite these unprecedented moves in what so many have called a “stock-pickers’ market”, hedge funds are picking stocks at the slowest pace on record. According to Goldman, hedge fund position turnover fell to 27% during 3Q 2016, a new record low. Turnover of the largest quartile of hedge fund positions, which account for two-thirds of hedge fund long holdings, fell to 14% (Exhibit 9). Turnover declined most in the Health Care, Consumer Discretionary, and Information Technology sectors.
We would expect this number to jump in coming quarters as the entire investment playbook is rewritten under an inflationary regime.
Finally, for all those curious, here is the latest GS VIP list, i.e., the Top 50 most popular longs…
… and the list of 50 stocks representing the most important short positions.
Traditionally, being long the most shorted hedge fund names and shorting the most favored ones has been a source of double digit alpha ever since 2011, but of course this time may be different.