In its latest quarterly hedge fund trend monitor - a survey of 804 hedge funds with $2.1 trillion of gross equity positions ($1.4 trillion long and $704 billion short) - which analyzes hedge fund holdings as of Sept 30, Goldman makes some interesting observations about the current state of the hedge fund industry. First and foremost, it finds that the average equity long/short hedge fund has posted a 10% YTD return, which while the strongest since 2013 is once again underperforming the S&P for the 7th consecutive year.
In terms of holdings, it's a continuation of what we discussed the last two quarters - everyone and their kitchen sink is plowing into high beta, "growty" and "momentum" tech names, and since most funds still underperform the S&P, the average net leverage is at all time high. Here's Goldman:
Fund performance has been lifted by sector (Information Technology) and factor (growth, momentum, large-cap) exposures. Our Hedge Fund VIP list of the most popular long positions, whose top five stocks are FB, AMZN, BABA, GOOGL, and MSFT, has outperformed the S&P 500 by 770 bp YTD (25% vs. 17%).
Also notable, while at least on paper hedge funds are expected to diversify, in reality the average HF carries 68% of its long portfolio in its top 10 positions, just below the record high reached in early 2016. Meanwhile, confirming that the market is afflicted by a creeping paralysis, portfolio position turnover fell to a new record low last quarter, at just 13% for the largest fund positions. Oh yes, and nobody is short: hedge fund short interest as a percent of S&P 500 market cap remained close to 2%, near the lowest level in five years.
Below are Goldman's 5 key observations from this edition of the HF Trend monitor:
- PERFORMANCE: The average equity long/short hedge fund has returned +10% YTD on the strength of the most popular long positions, high exposure to Information Technology, and atypical factor tilts toward large-caps and away from value stocks. This ranks as the strongest return since 2013 and compares with 17% for the S&P 500, 16% for the average large-cap core mutual fund, and 2% for macro hedge funds.
- SECTORS: Information Technology remains the largest net sector exposure, accounting for 27% of fund portfolios. However, the 307 bp overweight tilt relative to the Russell 3000 is 100 bp smaller than at the start of 3Q. Materials represents the largest sector overweight. Financials is the largest underweight and a major source of disagreement with large-cap mutual funds, which are overweight the sector. Current overweights in Energy and Consumer Discretionary are nearly the smallest tilts in recent history, as is the underweight in Utilities.
- LEVERAGE: Hedge funds increased net leverage in 3Q 2017 as the most popular positions continued to outperform a rising equity market. Short interest as a percent of S&P 500 market cap remained close to 2%, near the lowest level in five years.
- VERY IMPORTANT POSITIONS: Our Hedge Fund VIP list (ticker: GSTHHVIP) of the most popular long positions has outperformed the S&P 500 by 770 bp YTD. The VIP list contains the 50 stocks that appear most often among the top 10 holdings of fundamentally-driven hedge fund portfolios. The basket’s absolute and risk-adjusted YTD returns rank as the strongest since 2013. The list’s top 5 stocks are FB, AMZN, BABA, GOOGL, and MSFT. The basket has outperformed the S&P 500 in 65% of quarters since 2001, generating an average quarterly excess return of 62 bp. 10 new constituents entered the basket this quarter, compared with a quarterly average of 16 stocks since 2001: EQIX, GDDY, IAC, IQV, MGM, MPC, NRG, SBAC, TTWO, and XPO.
- CROWDING AND TURNOVER: Hedge funds continue to demonstrate high conviction in their favorite positions. The typical hedge fund has 68% of its long equity assets in its top 10 positions, just below the record high of 69% in 1H 2016. Similarly, our crowding index increased but remains shy of its 2016 extremes. Quarterly turnover of the largest portfolio positions fell to new historical lows, at 13%, declining in all sectors but Health Care.
The biggest component of the favorable hedge fund return in Q3 was a result of the outperformance of the Goldman Hedge Fund VIP basket, also known as the "hedge fund hotel"index, a list of 50 names which are the most widely held hedge fund stocks. Good luck selling them during a firesale, as happened in early 2016 when the GSTHHVIP basket crashed, wiping out four years of gains in a few months.
With no crash yet, and despite softness during the last month, Hedge Fund VIP names outperformed the broad market YTD both in absolute and risk-adjusted terms according to Goldman.
The basket’s strong return has more than made up for its higher volatility (8 vs. 6 for S&P 500), combining for a YTD ratio of return/volatility of 3.0, above the ratio of 2.8 for the S&P 500 and the best since 3.2 in 2013.
What is more concerning is that as discussed the past two quarters, the trend of growing hedge fund leverage (to make up for loss of alpha), continues, and according to Goldman, funds added net leverage entering 4Q. Data calculated by Goldman Sachs Prime Services on exposures in their business show that net leverage has risen in recent months and is near cycle highs.
Meanwhile, everyone has given up on shorting: in fact, short interest as a share of S&P 500 market cap sits just below 2.0%, matching January of this year as the lowest level since 2012. Relative to trading volumes, the short interest ratio (days to cover) ranks higher compared with history but still far below the cycle high in 2015.
Predictably, with market leadership increasingly more concentrated, and with fewer leaders, the density of hedge fund portfolios is near all time highs.
Hedge fund crowding in the most popular positions rose slightly in 3Q 2017 but remains below the extremes reached in 2016. The average hedge fund holds 68% of its long portfolio in its top 10 positions, just below the record “density” of 69% in 1H 2016. The increase in hedge fund portfolio density mirrors the growing share of S&P 500 market cap accounted for by the 10 largest index constituents, which has risen steadily for two years but even now sits near the average level since 1990.
As a tangent, those who were long tech, remained long tech as the average infotech portfolio turnover dropped to the lowest on record.
So putting it all together, here are the 50 positions which make up the latest GS VIP list, i.e., the 50 most popular hedge fund longs...
... and the list of 50 stocks representing the most important short positions.
Finally, here are the 20 stocks with the highest positive and negative changes in popularity.
As a reminder: traditionally, being long the most shorted hedge fund names and shorting the most favored ones has been a source of double digit alpha ever since 2011, and while this year that may have been different, for now, there is no reason to assume this normalcy will persist especially once the revulsion with tech names reappears once more.