Why Hedge Funds Remain The Worst Performing Asset Class Of 2016

It's been a bad year for hedge funds as a result of significantly underperforming the market, coupled with the biggest wave of redemptions since the financial crisis. Unfortunately, according to the latest Goldman data, there is no reprieve in sight. As the following chart from David Kostin shows, both global macro hedge funds and equity long short funds are the worst performing assets YTD on both a total return and risk-adjusted basis.

There are two main reasons why hedge funds continue to underperform: on one hand correlations across various sectors have soared to the highest levels in the past three years, leading to a plunge in return dispersion making "stock-picking" virtually impossible...

... while on the other hand, the most popular hedge fund short positions have soared in recent months, crushing short books and more than offsetting the modest rebound in the "hedge fund VIP" basket of most popular positions.

And while hedge funds have continued to underperform, several outright sectors continue to dramatically outperform the S&P, most notably IT, followed by Consumer Staples, Telecom and Utilities, even if the latter three have seen some modest weakness in recent months as a result of the pick up in yields.

... leading to the following most recent return by sector, where despite the recent surge in IT, Utilities still have the YTD lead, followed closely by Telecom and Energy.

Shifting away from sectors, and focusing only on valuation factors, we find that size (in this case small is better), high margins and low dividend yield have become increasingly expensive, while on the other end, low momentum, low margins and high volatility are now the cheapest inputs into quant models.

Shifting back out, we then look at the overall market where we find the valuations on both an absolute and relative basis remain especially rich, with the S&P trading at a 17.3x forward PE, and while financials and telecom remain cheap, at 12.6x and 13.9x fwd PE respectively, they are more than offset by the lunacy in Energy stocks which trade at over 43x, while consumer staples is the second richest sector currently.

Finally, putting it all together shows that mutual fund outflows continue, with some $127 billion withdrawn from equity mutual funds, and even ETFs now negative YTD; both of these are more than offset by the $110 billion in inflows in bond mutual funds and ETFs, while as a result of the upcoming change to money market fund regulation, those particular funds keep bleeding cash, having lost some $124 billion YTD. Also worth noting, a marketwide short squeeze as a drive of upside is no longer a key concern as a result of the S&P's median short interest as a % of market cap sliding to 2.4%: the lowest since last summer.