Will the Long/Short crowd dump more stocks and exacerbate the ongoing market turmoil/chop? Yes! No! I don’t know, maybe!
We’ve reached that manic stage where every other article in the mainstream financial press revolves around trying to find out who was selling or who might be inclined to sell next. “We have found a witch, may we burn her?!”
The latest example of this is a Bloomberg piece out Sunday evening and “updated” on Monday (although I’m not even sure what that means in this context) called “Hedge Funds Have Stocks to Dump, in Bad Sign for Sell-off.”
The amusing thing about that article is that it’s based on the assessment of one Jason Goepfert, President of Minnesota-based Sundial Capital Research, and it sounds to me like Jason is using the same moving beta chart to justify his contention that the Long/Short crowd has more stocks to dump that other analysts have used to justify the exact opposite contention.
And look, everybody has a claim on being “right” here. This is the chart (and I’ll explain the annotations below):
(Bloomberg)
What you’re looking at there (ostensibly) is the Long/Short crowd aggressively paring exposure during the February selloff (first red shaded box), remaining gun shy from March through July, then panic-grabbing as the market left them behind and rallied to new highs in late August and September (green shaded box). Unfortunately, they appear to have top-ticked that exposure (at record levels no less) on the eve of the massacre and the subsequent de-leveraging (second red shaded box) likely contributed to the October rout.
That put them in an exceptionally awkward spot headed into November. If the market rallied, the aggressive de-netting/de-grossing/de-beta’ing left them underexposed and thus meant they wouldn’t participate in the upside. In fact, it seems like they may have low-ticked it (exposure wise) at the tail-end of October just before a powerful two-day U.S. equity rally.
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Exodus: Retail Investors Run Screaming To Cash As Hedge Fund Exposure Plunges To 2017 Lows
Data from Goldman’s prime desk last month showed net and gross exposure falling to the lowest levels since the first half of 2017.
(Goldman)
Well, according to the same simple measure shown in the chart above, some exposure was being gingerly rebuilt last month. You can kinda, sorta see that in the zoomed version:
(Bloomberg)
Needless to say, that didn’t turn out all that well considering what happened to U.S. equities last week. The worry, according to the Bloomberg piece linked above, is that because hedge funds’ exposure hasn’t been trimmed to historic lows, last week might have been especially demoralizing for active managers who had rebuilt exposure in November, and they might be inclined to sell more in disgust.
Let’s look at Friday (which was a bloodbath) for instance.
“Friday’s US Equities trade-flow was consistent with that of ‘risk management’-dictated behavior (especially due to the proximity to year-end), with funds showing zero tolerance for further drawdown”, Nomura’s Charlie McElligott wrote on Monday, noting that “by the end of the day, Equities Long-Short and Market-Neutral performance looks to have made fresh YTD lows.”
He gets more granular with it. “Friday’s exposure reduction wasn’t about ‘book-down’ / ‘gross-down’ however, it was instead about taking down your ‘nets’ (long exposure less short), with popular longs being ‘hate sold’ while at the same time seeing shorts pressed hard in a clearly more defensive posture as funds look to ‘shut it down’ through the end of the year.”
(Bloomberg)
He then delivers a pretty poignant message about the extent to which the old narrative (i.e., the “it’s so easy” story) has been summarily relegated to the annals of history as the QE/Goldilocks trade suddenly morphed into the QT/late-cycle leadership baton-passing trade.
“Get your arms around this QTD performance from the Factor Market-Neutral perspective, versus the same factors’ performance in 1Q18 which could be categorized as ‘Peak Sharpe / Momentum / Easy Carry’ of the old ‘QE era'”, he writes, describing the tables below and remarking that this “crystalizes the regime-change and the ‘late-cycle’ transition into the ‘QT era’ and the current US Equities zeitgeist.”
And there’s more color from Charlie, who goes on to detail offsides hedge fund positioning, noting that their “books were effectively ‘long high beta and short low vol’ over the entirety of the year and now, we see ‘the purge’ nearing completion, with Beta market-neutral -18.5% QTD and the largest 2.5m move since the China growth / Crude disinflation/US HY Energy credit scare of late 2015/early 2016 that ultimately preceded the infamous Shanghai Accord.”
(Bloomberg, Nomura)
The point in going through all of this is simply to underscore the notion that this crowd has been shellshocked in 2018 and they face a vexing quandary into year-end. If they sell more/pare long exposure and their shorts don’t work out, then they risk falling further behind (i.e., underperformance gets worse). If they re-risk, they could run into another week like last week.
Coming full circle, it’s not at all clear who’s “right”. Hedge funds have pared exposure materially since October, but depending on who you want to ask, that exposure is still “elevated” versus history. And they’re trying to negotiate what looks like an epochal shift away from what’s worked for years and towards late-cycle plays despite not knowing whether the rotations we’ve seen over the last two months are really just a false start in that regard.
All we know for sure is that on the simplest of simple reads (i.e., just making a bar chart of the HFRX Equity Hedge index) this has been the worst year since 2011.
(Bloomberg)
The “hedge” in hedge funds was really a joke. For many it didn’t pay to hedge. For many the firm was gone so it became a moot point. What was left was a lot of long growth/momo funds. And we saw what happened, being offsides when reality hit. Hopefully we get back to true hedge funds. The carnage has left some opportunities. Who knows where the bottom is but if one buys something for less than it is worth and shorts the stories and dreams and the inputs are reasonable and the investor base has a reasonable time horizon the returns in a non QE environment will look really good.
I for one have waited for this change, I think rationality is finally back.
These articles are written as if they are going to find their way into a mystery novel. Hedge Funds in aggregate have too many assets, the factors that make it an alpha winning gambit has almost disappeared and now there are redemptions galore. The smart money has simply stepped aside to buy the stocks that must be sold at lower prices and when the calendar shifts much of the liquidation will be complete. It is as simple as that!!!!