Yesterday, when we revealed the top 50 hedge fund long and short positions, we showed that after a record stretch of underperformance for the most popular stocks held by hedge funds, aka the Goldman Sachs hedge fund VIP basket, had finally posted a modest rebound.
As Goldman's Ben Snider pointed out, "during the last six weeks Goldman's Hedge Fund VIP basket of popular long positions has led the S&P 500 by 470 bp, ending the basket’s record 1500 bp stretch of underperformance since August 2015" to which we added that even with the recent rebound, as the chart below shows, any hedge fund that has merely bought the most popular stocks, or otherwise copied what everyone else was doing, is now back to a level last seen in 2008.
Yet even with the recent rally in the most popular long positions, the average hedge fund has returned just 3% YTD, lagging the S&P 500 for the eighth year in a row.
But even so, had the recent hedge fund surge been due to effective stock picking and alpha generation, one could be allowed to speculate if the relentless redemption wave which has hit the hedge fund community may perhap slow down. Alas, when one looks at the sources of the VIP basket outperformance, what one finds is hardly supportive of hedge funds' returning to their old "alpha-generating" roots, because it appears that just two things drove the July and early August rebound.
First, massive short covering. As we pointed out earlier this week, the "shorts have thrown in the towel", as theshort interest on the S&P has plunged in the past year. Goldman confirms as much: "Short interest rose in late 2015 but has fallen noticeably during the last few months. The short interest ratio (days to cover) currently sits at 2.9, the lowest level since April 2014. The steady growth of shorts in the US equity market from 2002 to 2008 accompanied the rise in hedge fund assets. We estimate that hedge funds account for 85% of all short positions."
So the first factor for the move higher was simply the latest short squeeze, which forced rampant buying of not only the most shorted stocks (listed here), but of the overall market.
What about the second factor? Well, that may be even more embarrassing for the "smart money" community, because instead of even trying to uncover alpha, what most hedge funds did is jump on beta. With leverage, to wit:
Risk appetite had declined substantially during the last 12 months, but hedge funds increased leverage sharply at the beginning of 3Q. We estimate hedge funds in aggregate operated at 43% net long exposure in 2Q, down from a record high of 57% in early 2015.
After months of declining market exposure, the sharp increase in hedge fund leverage in recent weeks has helped drive VIP outperformance. Goldman Sachs Prime Brokerage reports a surge in net long exposure to 63%, approaching the highest levels in 12 months, from below 50% in 2Q. After declining during 2015 and 1H 2016, leverage bottomed at the end of 2Q, and in subsequent weeks funds boosted market exposure as stocks rallied. In addition to adding leverage through cash equities, call option volume rose to record levels, hedge fund S&P 500 futures exposures climbed by $15 billion, and the share of S&P 500 market cap held short fell to a 1-year low.
The dramatic surge in hedge fund leverage in the past two months is shown below:
And there it is: the 6 weeks of solid hedge fund outperformance was courtesy of a major short squeeze, facilitated by a near record surge in hedge fund leverage. Which is great on the great up, the only problem is that leverage works both ways, and should the market roll over from its daily fresh all time highs, the second part of the ride will be far less enjoyable for the hedge fund industry, especially with far fewer shorts left to cover. As such, it is not surprising that in recent conversations with HF desks, the prevailing question has been not whether it is too late to still buy, but when is the right time to start selling, ideally just before everyone else does.