It has been a bad year for most markets. It has also been a bad year for those entities who collect 2 and 20 to "hedge" against bad years for markets: hedge funds. Unfortunately, as we have said since 2009, most hedge funds tend do anything but actually "hedge" which is why as Goldman's latest HF tracker reports, hedge funds have only modestly outperformed a weak S&P 500 YTD following their reduction in net long exposure to 45% at the start of 2016, the lowest level since 2012. Most are down for the year.
The reason for this underperformance is that the most popular positions continued to suffer as the reversal in momentum hurt highly concentrated hedge fund portfolios. The average fund holds 68% of long assets in its top 10 positions, most of which happen to be momentum driven. Perhaps instead of "hedge funds" they should be called "momentum funds"?
Some further observations from David Kostin:
Despite reduced risk-taking at the start of 2016, the momentum reversal in January hurt heavily concentrated hedge fund portfolios, prompting further de-risking and contributing to a vicious cycle that compounded the underperformance of the most popular hedge fund positions. Momentum (the continued outperformance of past leaders) was a powerful trend in 2015, rising roughly 50% from May until its sharp reversal in mid-January (see Exhibit 4). As momentum reversed, our Hedge Fund VIP list of the most popular hedge fund long positions also lagged. The basket (ticker: GSTHHVIP) has underperformed the S&P 500 by 386 bp YTD (-10% vs. -6%).
As a reminder, Goldman is now trying to make its Hedge Fund VIP basket into an ETF in an effort to make it easier for underwater HFs to offload exposure to retail investors as few other hedge funds, most of whom are already in the same positions, have any interest. Some more observations on said basket:
Our hedge fund VIP list (Bloomberg ticker: <GSTHHVIP>) consists of stocks in which fundamentally-driven hedge funds have a large position. We define stocks that “matter most” as the positions that appear most frequently among the top 10 holdings within hedge fund portfolios. For this analysis, we limit our universe to hedge funds with 10 to 200 distinct equity positions in an attempt to isolate fundamentally-driven investors from quantitative funds or funds that mirror private equity investments.
Here is the problem: while the basket of the 50 stocks that “matter most” outperformed the S&P 500 by more than 700 bp in 2013 (41% vs. 34%) and by 265 bp during 2014 (16.3% vs. 13.7%), it trailed the S&P 500 by 384 bp in 2015 (-2.5% vs. +1.4%) and is off to a rough start in 2016, lagging the market by nearly 400 bp YTD.
Here's the problem: clustering has become endemic for hedge funds, who having run out of alpha-generating ideas have all rushed into the same positions, and nowhere is this more visible than in the hedge fund exposure to FANGs, which has been the key reason for disappointing hedge fund performance.
Equity long/short hedge funds were especially harmed by the momentum reversal given the widespread ownership of high-flying consumer-facing technology stocks. These momentum leaders included firms such as FANG (Facebook, Amazon, Netflix, and Alphabet/Google) that posted stellar returns in 2015 and rank as constituents of our VIP List. Because of the popularity and performance of these stocks, “FANG” rocketed from roughly 1.5% of hedge fund US equity assets at the start of 2015 to 3.5% at the start of 2016. More broadly, fund portfolio density reached the highest levels on record. With the average fund holding 68% of long assets in its top 10 positions, funds have become especially dependent on the performance of a few key stocks.
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Which brings us to the topic of this post: how to outperform most hedge funds. The answer is simple, and two-fold. First, as we have said on many occasions in the past year, simply do the opposite of what hedge funds are doing. As the market rotated away from momentum and popular positions, the stocks least owned by hedge funds soared. Goldman's Low Concentration Basket (GSTHHFSL) consists of the S&P 500 firms with the smallest share of market cap owned by hedge funds. This strategy has posted a mediocre historical performance record, outperforming the S&P 500 in 53% of quarters since 2001. This year, however, the basket has outperformed the S&P 500 by 541 bp (0% vs. -6%) and outperformed by nearly 9 pp during the past six months, equating to its strongest six-month return outside of 2008 and 2002.
Investors who believe hedge funds are wrong and will remain directionally wrong and who wish to own equity risk but remain relatively insulated from the volatility caused by changes in hedge fund positioning should find this basket attractive. New constituents include ORCL, CVX, and UPS.
Here is Goldman's list of the 20 least concentrated equity holdings:
Of course there is a far simpler way to beat most hedge funds: just be long gold.