How Hedge Funds Closed Out 2016, And Why Hopes For A 2017 Rebound May Disappoint

2016 was a year most hedge funds would be happy to forget. And while the same goes for 2015, 2014, 2013, 2012, 2011, and 2010, in fact virtually every year since the financial crisis in which the vast majority of the two and twenty crowd have failed to generate alpha, in 2016 - a year many said would mark a renaissance for active managers - the "flash hedge fund return" according to a report by BofA's Paul Ciana from Friday was a paltry 3.34%, which as BofA conveniently calculated meant they "underperforming the S&P500 index by 6.2%" at which point your average underperforming hedge fund manager complains that they shouldn't be benchmarked against the S&P, even as the redemption notices flood in and the AUM gets ever smaller.

Not everyone did poorly: credit related strategies lead HF performance, including Distressed Credit, Convertible Arbitrage and Event Driven strategies. On the other end, predictably, dedicated Short Bias was down 5.10%

Looking at specific names, the following HSBC table breaks out the best and worst hedge funds as of the last week of December 2016:

In recent weeks there has been a fresh burst of hope that 2017 will be better for the HF community as a result of the recent collapse in cross-asset correlation; it is hoped that the resulting returns dispersion will make it easier for hedge funds to stand out in a world in which due to central bank intervention, correlations had been abnormally high following the financial crisis.

But is that an accurate description of events?  To a great extent, the answer is no.

While correlation between diversified HF performance and S&P 500 price return declined from the May 2016 high (Chart 1), the 1-year correlation (83.7%) was slightly above the 3-year correlation (83.0%) as of the end of November. Overall, correlation remained far higher than it has been historically. Which as BofA redundantly explains, means that "when S&P 500 declines, performance of HFs with higher positive correlation is expected to suffer."

Not all "hedge" funds have such a high correlation, however. The correlation relationship with S&P 500 varies substantially among different HF strategies. Short Bias and Merger Arbitrage offer negative  correlation or most diversification effects. Equity focused HF strategies, including Equity Market Neutral and Long/Short, has decreased correlation to the S&P 500 compared to longer term relationship (3-year and 5-year). On the other hand, Distressed Credit, Convertible Arbitrage and Event Driven have increased positive correlation (Chart 2).

Yet, while there are some notable exceptions, the rule generally is that as the market goes, so goes the average hedge fund. Which is why some of the world's wealthiest billionaires are pleading that Trump does not disappoint and manages to keep pushing the S&P to ever higher records on nothing but hope of a "fiscal stimulus" which may well never come.

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That said, how did hedge fund close out 2016? Here is the answer based on the latest weekly CFTC data:

  • Buy-side net long in WTI Crude was near record high (99.4%-tile). However, trend remains bullish absent a move below 44.1/42.2 (50-week SMA and chart support).
  • Institutions added to their long in 30-year Treasury future to the highest since July 2015; HFs added to their short in 30-year to the most since Feb. 2015. Technical bias favors a bullish rebound of the 30-year Treasury.
  • Buy-side was most short JPYUSD since December 22, 2015. However, net position was 42% less than the short seen in Jan. 2007. Although JPY strengthened during the past 2-weeks, the longer term trend favors further depreciation against USD absent a move below 114.97/114.74.

Notable flows last week (12/20/2016 to 12/27/2016):

  • Institutions sold $5.5bn S&P 500, $0.7bn Russell 2000 and $0.6bn MSCI EM futures last week. HFs sold $0.4bn MSCI EM and $0.3bn Russell 2000, but bought $4.7bn S&P 500 and $1.1bn NASDAQ 100.
  • Institutions bought $9.8bn 10-year and $2.3bn 30-year Treasuries, while selling $1.9bn 2-year. HFs sold $10.1bn 10-year and $2.7bn 30-year, but bought $3.9bn 2-year.
  • HFs increased their shorts in EURUSD and JPYUSD, by $0.1bn and $3.2bn, respectively. Institutions added -$0.2bn to JPYUSD shorts, and sold $0.7bn of their longs in EURUSD.
  • CTAs/CPOs sold $1.2bn Gold and $0.3bn Silver, but bought $0.6bn WTI Crude.

The key fufutres categories, visualized:

Equities: S&P500

Equities: Nasdaq

Equities: Russell

Equities: Emerging Markets

Treasurys: 30Y

Treasurys: 10Y

Currency: Euro

Currency: Yen

Commodities: Gold

Commodities: WTI

Source: BofA