It all started about three years ago when we first advised readers who were inclined to so gamble, that the only way to win in a rigged, maipulated market, one in which central bankers are now Chief Restructuring Officers and will not allow even a modest correction to asset prices, that the easiest way to generate “alpha” was to go long the most hated names.
Then, in mid-February, just as the market had bottomed and was about to unleash a historic short squeeze, we had a follow up article, in which we explained in very simple terms “how to outperform most hedge funds in 2016.”
The answer is simple: 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.
In other words, go long the Least Concentrated and/or Most Shorted by hedge funds, stocks. We also said to avoid (or simply short for those who prefer pair trades) hedge fund clustered positions, best represented by such indexes as Goldman’s Hedge Fund VIP List (GSTHHVIP): “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.”
Here is a visual snapshot of how this trade has performed in the recent past:
As of this moment, the HF VIP basket – i.e., the most widely held stocks among the hedge fund world – is trading at 5 year lows, while the Low Concentration basket is at all time highs. In other words, anyone who had done as we suggested three months ago, would have indeed outperformed about 95% of all hedge funds in 2016. We bring attention to this out mostly to those who seems to be left with the erroneous impression that this website pushes some “short stocks” agenda and is bearish no matter what.
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Which brings us to today when the always so insightful, if only in retrospect, explains why hedge funds have had such an abysmal quarter.
Most hedge funds have continued to struggle in 2016, with the US equity market’s flat YTD return belying the volatile factor and sector rotations beneath the surface. For example, after rising by 34% in 2015, our long/short S&P 500 momentum factor fell by more than 20% in the first four months of 2016 before rising more than 10% in the last month (Exhibit 1).
And here is the official explanation
The outperformance of the largest hedge fund short positions relative to the most popular longs helps explain the especially weak returns of equity long/short hedge funds. The average hedge fund has returned -2% YTD compared with +1% for the S&P 500. Among major fund styles, equity long/short funds have posted the weakest returns (-4%), according to HFR data, as our Hedge Fund VIP list (ticker: GSTHHVIP) of stocks appearing most frequently as top 10 long positions lagged our Very Important Short basket (GSTHVISP) by 940 bp (-6% vs. +3%). The VIP basket’s 13 percentage point underperformance relative to the S&P 500 since August 2015 matches the basket’s worst previous drawdown, which occurred during 2008 (page 8). The record levels of portfolio density discussed on page 7 underscore the importance of VIPs for fund performance.
In other words, Goldman’s reason for why hedge funds have had a disastrous quarter? Simple: they listened to Goldman, and all piled into the same positions which have blown up in spectacular, serial fashion leading to one of the biggest hedge fund industry drawdowns in recent history.
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