The Simplest Reason Behind Collapsing Volatility: Hedge Funds Are Barely Trading

"Gamma", "vega", CTAs, risk-parity, vol-neutral, central bank vol-suppression, the soaring popularity of (inverse) VIX ETFs , and so on: over the past year there have been countless attempts to explain why despite the surging political uncertainty in recent years, and especially since the US election...

... global equity volatility, both implied and realized, has tumbled to record lows, sliding even below levels not even seen before the 2008 financial crisis.

There may be a much simpler reason.

In its latest hedge fund tracker report, which every quarter analyzes the 13F filings by US hedge funds, Goldman found something quite striking. When looking at the gross portfolio turnover of hedge funds in Q1, the bank found that it had retreated to a record low at 28% of positions in 1Q 2017.

At the same time, turnover of the largest quartile of hedge fund positions, which account for two-thirds of hedge fund long holdings, fell to 15%, close to its lowest level since 2002. As a result the typical hedge fund has 67% of its long equity assets invested in its 10 largest positions, a decline from last quarter but still near historical highs.

This suggests that in the first quarter, hedge funds found themselves even further "paralyzed", and for whatever reason have reduced overall trading levels to all time lows. This further suggests that with virtually no trading by the "smart money", those traditionally most likely to put on "volatile" positions, contrary to consensus, the bulk of executed trading took place among passive funds and other trend followers, which would facilitate and accelerate the ongoing decline in volatility.

Stated simply: volatility has collapsed for the simple reason that increasingly fewer directional, non-momentum chasing market participants are actually trading.

But if hedge fund turnover has collapsed, how do these "active managers" hope to generate alpha? One explanation is that in lieu of stock picking, hedge funds have simply lifted leverage to post-crisis highs as their most popular long positions outperformed in a rising equity market. The Goldman Sachs Prime Services Weekly shows that, after bottoming in mid-2016, hedge fund net and gross exposures have continued to rise. Net exposure (73%) is now roughly in line with its cycle highs reached in 2013, while gross leverage (234%) has soared to new post-crisis highs.

This dynamic has contributed to a virtuous cycle as our Hedge Fund VIP basket of the most popular hedge fund long positions rallied, outperforming the S&P 500 by 360 bp YTD (10.1% vs. 6.5%).

And while such dramatic concentration among the top positions has been observed before, most recently yesterday when we showed the fresh collapse in market breadth vs the once again resilient "broader" market...

... this bring up another key concern: with the bulk of hedge funds holding just a handful of names - mostly tech stocks comprising the so-called FAANG, which as a group have returned nearly 30% and are responsible for half of the S&P YTD gains - proppeled to record highs by a fresh burst of momentum chasing, what happens when for whatever reason, this trade is unwound.

This is Goldman's take:

The rise in leverage alongside growing popularity of outperforming growth stocks has raised some concerns among clients, even while boosting their portfolios. Investors recall the sharp momentum reversal of early 2016, which came on the heels of a similar period of rising popularity and performance for “FANG” (FB, AMZN, NFLX, GOOGL) and similar stocks in late 2015.

Indeed, investors have reason to be concerned: for a vivid example of what happens when such "hedge fund" hotel trades go into reverse, look no further than Valeant...