There was a time when being short was a bad idea. Not anymore. As David Kostin' summarizes in his latest weekly chart packet, the level of 3 month S&P and sector correlation is now at a 20 year high, an environment which never leads to good outcomes for long-only whales, and which has led to sizable outperformance for hedge funds due to their recent loading up on short positions. To wit: "S&P 500 three-month correlation is 0.73, the highest in at least the past 20 years, and up from just 0.44 at the start of August. Sector correlation is similarly high, with all major S&P sectors experiencing realized correlation above their 95th percentile since the late 1980s. While it is difficult to specify a cause for higher correlation, a spike in S&P futures and ETF trading volumes and parallel reduction in open interest held by institutional and levered funds as reported by the Commodities and Futures Trading Corporation (CFTC) indicate significant de-risking in August." What does that mean for recent performance? Nothing good if one is a mutual fund: "Elevated correlation is generally considered a poor environment for long-only fundamental investors. In highly correlated sell offs the market does not discriminate based on company fundamentals, reducing the value of stock picking. Recent performance trends support that case." As a result hedge fund LPs are doing ok: "The typical hedge fund has generated a 2011 YTD return of -1% through August 19 compared with a -10% decline for the S&P 500 and an -11% return for the average large-cap core mutual fund." Alas, if the hedge fund in question is Paulson & Co., this average statistic is very misleading.
The 2011 hedge fund return story has two chapters. Hedge funds trailed during the first-half, posting flat returns on average with a 550 bp standard deviation while the S&P 500 rose 6% and mutual funds advanced 5%. However, the correction has pushed the S&P 500 3Q-to-date return to -15% as of August 19, while the typical hedge fund returned -2%. The distribution is wide as about 10% of funds returned 10% or more and 10% were down at least 10%.
What are hedgies holding?
Hedge funds are most overweight Consumer Discretionary, Info Tech and Materials. During the quarter funds increased their allocations to Info Tech and Discretionary by the largest amounts and decreased positions in Health Care and Industrials. Contrary to our recommended sector weighting, funds are underweight Consumer Staples and overweight Consumer Discretionary shares, a view also held by large-cap core mutual funds.
Hedge fund holdings of large-cap stocks continued their ten year trend higher. Roughly 47% of the aggregate assets of hedge funds is invested in stocks with equity capitalizations greater than $10 billion as of 2Q 2011, up from 35% in 2002. Just 18% of aggregate assets is invested in small-cap stocks (below $2 billion). The typical hedge fund allocates 35% of its assets to large-cap stocks and 33% to small-cap stocks. The difference between the average and aggregate suggests that the hedge funds with the largest assets under management target large-cap stocks.
Shorting helps offset massive losses:
The typical hedge fund short portfolio has helped offset losses. We estimate that hedge funds account for 85% of all short positions and construct a proxy of the “typical” short portfolio. Those short stocks have been an effective hedge by underperforming the market but have actually outperformed the typical fund’s long positions. Funds reducing gross exposure by selling longs and covering shorts is one possible explanation. Single stock short interest declined in early August even while index level shorts rose (Exhibit 8). The short portfolio is down 18% since June 30 and 13% in August vs. the S&P 500 returns of 12% and 10% respectively.
Of course, it wouldn't be a Kostin report without the now traditional dose of empty hopium:
We see faint signs of market stability as large mutual fund outflows stopped last week, options imply lower correlation over the next three months, and the S&P 500 has settled into a range between 1120 and 1200 over the past three weeks, albeit with high intraday volatility. The average intraday trading range has been 3.5% in August, more than triple its average during the first seven months of the year
And some of the key charts: