What Hedge Fund Panic Looks Like

We have previously said a lot about the "hedge fund hotel" implosion observed in the third quarter, a quarter in which many of the hedge fund community's favorite stocks all suffered spontaneous disintegration leading to unprecedented drawdowns for some of the industry's "best and brighetst" names.

Now, it's Goldman's turn. In the firm's Q3 hedge fund tracker report we read that "from July through October, hedge fund favorite stocks posted their worst relative returns outside of 2008." Goldman continues by admitting that when all hedge funds pile up in the same handful of names, and when even a small disturbance appears, all 2 and 20 bets are off. The result: the firm's Hedge Fund VIP list of companies most beloved to the "smart money" suffered its worst perforamance since 2008 driven almost entirely by just one company: Valeant.

Our Hedge Fund VIP list (ticker: GSTHHVIP) of most popular long positions underperformed the S&P 500 by 720 bp during that three-month window (-8% vs. -1%) as a sharp downturn in Valeant Pharmaceuticals (VRX) and other previously high-flying healthcare stocks weighed on fund returns. After outperforming the S&P 500 by 7 percentage points (pp) in 2012, 9 pp in 2013, and 3 pp in 2014, the VIP list has lagged the S&P 500 by 5 pp year to date (-2% vs. +3), putting 2015 on pace to match 2011 as the worst year for hedge fund favorite stocks post-crisis. With its 66% decline since the VIP list’s last rebalance in August, VRX alone accounted for 26% of the basket’s negative return. Healthcare in aggregate accounted for nearly 70% of the fall.

The result: hedge funds are not only about to post their 7th consecutive year of S&P500 underperformance, but the entire "2 and 20 model" is in greater jeopardy thatn ever, which incidentally is what we have said all along: who needs to "hedge" when you have every central bank in the world doing everything in their power to avoid even a 5% decline in the "market"?


And to think that until a year ago, countless hedge funds could not shut up during idea dinners pitching the "no brainer" upside in names like Allergan and Valeant. One year later, marquee asset managers like Bill Ackman are fighting for their investment lives and praying not to get redeemed out of business.

Goldman continues:

The poor performance of favorite long positions has weighed on aggregate hedge fund returns, which entered negative territory during the market correction in August and have yet to recover. The average hedge fund has returned -2% YTD in 2015, compared with +3% for the S&P 500 and +2 for the 7-10-year Treasury ETF. Event-driven hedge funds have fared especially poorly, with the typical fund down 6% YTD.


And this is what hedge fund panic looks like: after being one of the top 10 most widely held names as recently as Q1, Valeant has seen a plunge in not only its stock price, but also the number of fund who own it. One can be 100% certain that as of November 20 the number is vastly lower than the 87, already a one year low, recorded as of Sept 30.

Perhaps if only these "smartest people in the room" had actually done their diligence instead of rushing to buy a stock just because others bought the stock or, gasp, hedged their exposure, none of this would have happened. But then again that means doing actual work - why bother when all the idea dinner participants can just hope nobody pulls a SIRF and uncovers a specialty pharmacy ticking time bomb hiding just below the surface.

So with all that in the rearview mirror, surely the HF industry has learned its lesson and will henceforth stay away from massively concentrated, illiquid positions, right? Wrong...

Despite the Valeant share price collapse and subsequent hedge fund shift away from former high momentum leaders, funds continue to own the handful of outperforming mega-caps that have driven historically narrow market breadth in recent months.

... a handful of mega-caps which as we showed earlier this week, represent primarily high growth, consumer-facing tech companies, which have accounted for the overwhelming majority of the index total return.

Finally this: the last time hedge funds were as unhedged as they are now, and instead have had the highest concentration of "top 10" names, was in 2008.

Hedge fund returns continue to grow more dependent on the performance of a few key stocks. The typical hedge fund has an average of 67% of its long-equity assets invested in its 10 largest positions, continuing the trend of higher “density” in the past decade and reaching the highest level since the Financial Crisis. This statistic compares with 33% for the typical large-cap mutual fund, 22% for the average small-cap mutual fund, 18% for the S&P 500 and just 2% for the Russell 2000 Index.

For the sake of these "smartest people" in the room - who so very often turn out to be anything but - we hope there are no more "Philidor" moments among the remaining super-concentrated holdings, or very soon the myth that these investors are in some way "smarter" will have as little credibility left as the Fed itself.