Goldman: "Hedge Fund Returns And Leverage Have Entered A Vicious Downward Cycle"

The last time we looked Goldman Sachs Hedge Fund VIP index one month ago, it confirmed what we already knew, namely that it was in freefall as the pain for hedge funds refused to stop. Now, in its latest quarterly hedge fund tracker, Goldman digs into the just released barrage of 13F filings, analyzing the holdings of 823 hedge funds with $2.2 trillion of gross equity positions at the start of 4Q 2018, and finds even more bad news, namely that "hedge fund returns, portfolio leverage, and the performance of popular stocks have entered a vicious downward cycle."

As one would expect, Goldman strategist Ben Snider being by looking at the bank's proprietary hedge fund performance index, and finds that after outperforming in 1H 2018, the Hedge Fund VIP basket of the most popular long positions has lagged the S&P 500 by 725 bp since mid-June (-9% vs. -2%) alongside a downturn in growth and momentum stocks and rise in S&P 500 volatility.

As a result of the adverse combination of headwinds from alpha and beta, the average equity hedge fund YTD return has tumbled to -4%, returning +2% through May before declining 5% in recent months, including a -4% return in October; the recent sharp declines have forced funds to cut gross and net exposures even more, to the lowest levels since 1H 2017, weighing further on the most popular positions.

As is widely known by now, the biggest culprit for yet another year of woeful hedge fund returns was the high exposures to growth and momentum stocks, which eroded alpha as these factors declined in the second half of 2018. Growth and momentum stocks, including the popular “FANG” stocks, continued their 2017 outperformance in early 2018 but have lagged since mid-year, bringing down hedge fund returns with them.

Returns for the 2 and 20 crowd were additionally crippled by capitulating on timing the market bottoms, instead choosing to delever into the growing market turbulence. As we noted last night, hedge fund net exposures have steadily declined throughout 2018, including during 2Q and 3Q while the broad equity market rallied. Net long exposure calculated based on 13-F filings and publicly-available short interest data registered 49% at the start of 4Q, a decline from 56% at the start of 2018. Data calculated by Goldman Sachs Prime Services show a similar picture, with net leverage peaking in January 2018 and declining steadily since.

Curiously, while net exposures declined all year as a result of adding more shorts - most of which ended up blowing up at every bottom resulting in furious short squeezes that only detracted from overall performance - gross exposures remained elevated until the recent equity drawdown. In fact, according to Goldman data, gross exposures only declined sharply since the S&P 500 turned lower in early October. Yet while both net and gross exposures are currently at the lowest levels since 1H 2017, they remain significantly above levels earlier this cycle, including the lows alongside concerns of recession in early 2016, suggesting that if the selloff continues, even more outright liquidations are possible, especially if redemption requests continue piling in into the end of the year as LPs demand to be cashed out.

Which is not to say that there were no major rotations under the surface, because there were. Having been burned by the tech sector in Q2, hedge fund sector allocations reflected a continued defensive shift in Q3, with funds continuing their rotation into Health Care and away from Info Tech, which may explain the furious slide in the FANG and tech sectors as more funds joined the liquidations.

As a result of this defensive shift, Health Care now accounts for 18% of hedge fund net exposure, representing a 385 bp overweight versus the Russell 3000, the largest of any sector, as long gone are the days when hedge funds bet it all on growth.  According to Goldman, funds also incrementally tilted toward the defensive Utilities and Consumer Staples sectors.

And, not surprisingly, funds reduced exposure to perennial favorites Consumer Discretionary and Info Tech. In fact, Tech now represents the largest underweight.

Although long portfolio allocations in the sector were largely unchanged in 3Q, Tech weight in short portfolios grew from 17% to 18% as increasingly more funds shorted tech outright. Funds also reduced their overweight in the new Communications Services sector but remain overweight relative to the Russell 3000. In contrast to the defensive trend, funds modestly increased positions in Industrials and Financials

Also worth noting is that one of the largest increases in hedge fund sector allocation was toward Utilities, with the defensive sector now representing an overweight for the first time since 2008. Funds benefited from this increased tilt; amid concerns of decelerating economic growth, Utilities has been the best-performing sector since the start of 4Q (+5% vs. –7% for the S&P 500). Two Utilities stocks were added to the Hedge Fund VIP basket this quarter (VST and PCG).

Putting relative hedge fund exposure in context, Goldman finds that a number of current hedge fund net sector tilts stand out as extremes relative to the last decade. The Utilities overweight is the largest in the recent past, and the 503 bp tilt away from Information Technology is the largest underweight since 2014. Among the classic cyclical sectors, hedge fund overweights in Energy and Materials are at or near decade lows, while the Industrials overweight is a record high.

Summarizing the relative exposure - in terms of estimated hedge fund long, short, and net exposure, by sector - as hedge funds entered Q4, they were most overweight healthcare, and most short information tech.

Yet even as hedge funds rotated away from tech and into healthcare and utilities, a surprising reversal was seen in the hedge fund concentration in top portfolio positions, which actually increased in 3Q, mirroring narrow market breadth in the equity market. As a result, the average hedge fund holds 68% of its long portfolio in its top 10 positions, slightly below the record “density” of 69% in 1H 2016.

And here is the punchline for why hedge funds were hit especially hard in Q3: the share of S&P 500 market cap accounted for by the 10 largest index constituents reached 24% during the summer, the highest share this cycle, consistent with the narrowing evidenced by other measures of market breadth.  However, during the latest equity market volatility this share has tumbled from its highs as the hedge fund darling were whacked.

And one final observation: with the market hitting an all time high just as Q3 ended, hedge funds became even more complacent and portfolio turnover declined further in 3Q 2018. Across all portfolio positions, turnover fell by 2 pp to 25%, close to the record low reached in mid-2017, while turnover of the largest quartile of positions, which make up the vast majority of portfolios, fell slightly to 14%.

It is this lack of changing the most popular positions that ended up crippling returns the most as hedge funds entered the bloodbath that was October.

Finally, for those asking just which were the 20 most and least concentrated hedge fund holdings according to Goldman, that caused so much pain, here is the answer.