Yesterday we presented Nomura’s observations on the reasons why despite the market’s ascent back to new all time highs, the bank had witnessed a “multi-month performance disaster for US equity funds.” According to Nomura’s x-asset strategist Charlie McElligott, the reason behind the underperformance of equity funds was three-fold and involved sharp moves across various factor strategies:
- A “Beta Grab” (HF L/S beta to SPX jumps to 89th %ile from 65th %ile the prior week)
- A re-adding of exposure to “Momentum Longs” (L/S beta to Momentum Longs leaps to 32nd %ile from the recent puke down to 10th %ile)
- All of this despite SPX sector-performance last week showing “pure de-risking”: Telcos / Staples / REITS / Utes / Healthcare as the five best sector returns, while the bottom-six sectors were Industrials / Financials / Tech / Consumer Discretionary / Materials / Energy
Today, in its latest quarterly hedge fund monitor report which is a compilation and analysis of the latest batch of hedge fund 13Fs, Goldman’s Ben Snider confirms as much, writing that “a difficult summer has reduced the YTD return for the average equity hedge fund to -1%” largely as a result of underperformance of some of the most popular hedge funds stocks. As a result, Goldman’s basket of the most popular hedge fund positions – where FaceBook is at the very top – has lagged the S&P 500 by 118 bp so far this year (6.7% vs. 7.9%).
And speaking of Facebook…
The plunge of Facebook (FB), entered 3Q as the most popular hedge fund stock. Before its disappointing earnings results, 230 hedge funds (28%) in our sample owned FB, making it the most popular position. The average portfolio weight for FB among those funds was 4%. Among the 642 funds with between 10 and 200 distinct equity positions, 98 held FB as a top 10 portfolio position, ranking it as the top stock in our Hedge Fund VIP list.
Visually, this is how a hedge fund hotel burns down:
In other words, for yet another year, one could have bought the SPY, avoided the “2 and 20”, and outperformed the vast majority of hedge funds.
What caused this dramatic underperformance of Wall Street’s “best and brightest”?
According to Goldman, the large performance swings in the broad market and the most popular stocks “created a difficult investing environment.” Which then begs the question: why are hedge fund managers paid tens of millions if they can’t navigate “performance swings” and why do they all gravitate to the same handful of “most popular stocks”?
It certainly is not to build conviction: Goldman found that one contributor to underwhelming fund performance has been declining hedge fund net exposure. Net long exposure calculated based on 13-F filings and publicly-available short interest data registered 55% at the start of 3Q, slightly lower than in 2Q.
Data from Goldman’s Prime Services division showed a similar picture, with net leverage declining steadily during recent months while the S&P 500 recovered to within 1% of its record high.
But whereas lack of conviction is to be expected in a market that has grown increasingly decoupled between the US and the rest of the world, merely reducing one’s exposure would simply lead to more muted gains. To explain the underperformance there has to be a different reason: and sure enough, Goldman highlights just that, echoing a theme was have discussed constantly in recent weeks, namely the challenge hedge fund face as a result of the sharp outperformance of the most concentrated short positions.
Because at the same time that the most popular longs among hedge funds underperformed the S&P, a basket of the 50 Russell 3000 stocks with market caps greater than $1 billion and the largest outstanding short interest as a share of float has outperformed the S&P 500 by 14 percentage points YTD (+21% vs. +7%), Goldman found adding that in recent months, the concentrated shorts have outperformed primarily in favorite hedge fund sectors including Info Tech.
Which is a delightful confirmation of what we said back in May, when in addition to listing the top 50 hedge fund longs, we also listed the top 50 shorts and said “for those who are convinced that it’s only a matter of time before a massive squeeze sends the most shorted names soaring, here is the list of the 50 stocks representing the largest short positions among hedge funds.”
Fast forward three months later when the relentless short squeeze continues to crush hedge fund performance.
So is it too late now to piggyback on this trade, and hope for further “squeeze” higher?
Goldman’s answer is that whereas across the broad market, short interest as a share of float sits close to its 10-year median, but Consumer Staples short interest has rarely been higher.
As a result, the performance of retail stocks has been a good indicator of what happens once a short squeeze gets going: because although the sector faces pressure from rising interest rates and declining margins, the performance of retail stocks during the past year highlights the potential energy contained by stocks with extreme levels of short interest, and why in this market doing the logical thing is guaranteed to lead to acute pain.