Hedge funds swarm back to upended markets with short, long bets

AFTER spending much of 2022 playing defence, professional speculators are reasserting themselves with aggressive equity bets on both the short and long side.

Hedge funds have raised exposure in back-to-back weeks, data from Goldman Sachs Group’s prime brokerage show, increasing short sales via macro products such as index futures while buying shares of individual firms. The moves resulted in their busiest week by notional trading volume in a year. The same trends were observed by Morgan Stanley, where hedge-fund clients boosted holdings in single stocks in areas such as technology and health care while adding shorts against exchange-traded funds.

The data suggest that money managers are both keen to pick up bargains and leery about the broader market’s direction. At least 2 Wall Street firms warned that rules-based funds are expected to offload billions of stocks in coming weeks.

The equity activity also marks a reversal from what hedge funds were doing most of the year: unwinding risky bets, or degrossing, amid heightened market volatility.

The latest move is “indicating increased willingness by managers to play offence in micro/idiosyncratic situations while hedging beta risk using ETFs/index instruments”, Goldman analysts including Vincent Lin wrote in a note to clients Friday (Sep 2).

Stocks reversed overnight gains Tuesday, with the S&P 500 falling for the sixth time in 7 days. The index is hovering just above 3,900, a level that acted as support in mid-May and then worked as upside resistance briefly in June and July. A breach below the threshold would open the door for more selling, some chartists warn.

Risk appetite, generally, is in short supply aside from corporate America and day traders who have been buying the latest dip. The Federal Reserve is toughening its hawkish stance, Europe’s energy crisis is raging and China’s economy is reeling from its zero-Covid policy and a housing collapse. In the past few weeks, the S&P 500 has given up more than half of its gains from the summer recovery.

With momentum worsening after 3 consecutive weeks of declines, computer-driven funds - a big force at the centre of the summer rally - are no longer a bullish driver. Trend followers, such as commodity trading advisers, are poised to offload US$30 billion of shares this week, according to Morgan Stanley’s trading desk. A separate estimate from UBS Group suggested that amount of selling would occur over the next 2 weeks.

The cohort, which UBS estimates to have US$375 billion in assets, has exerted an outsize impact on the market as the fast money dashed in and out of stocks in a year of extreme volatility. They rode the market down by boosting bearish wagers during the S&P 500’s worst first half in 5 decades. Then as stocks recovered from the June trough, their massive unwind of short positions contributed to the S&P 500’s biggest bounce of the year.

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China-focused hedge funds lower exposure as risks mount

“CTAs have reduced/closed their bearish positioning in risky assets in July/Aug. But our model expects them to turn bearish again in September,” UBS strategists including Nicolas Le Roux wrote in a note. “The recent pullback in equities is likely to generate some selling pressures from CTAs in the next 2 weeks.”

Much like quant traders, stock-picking hedge funds have cut equity positioning this year. Net leverage among long/short hedge funds - a measure of the industry’s risk appetite that takes into account of long versus short bets - currently trailed 98 per cent of the time over the past 3 years, Goldman data show. At JPMorgan Chase & Co, client leverage sat in the bottom 1 per cent percentile since 2017, according to the firm’s prime broker.

Such cautious positioning is one reason why hedge funds have outperformed the market this year. It has also set the stage for rallies like the S&P 500’s 17 per cent jump from June to August when money managers felt compelled to chase gains.

Yet to JPMorgan analysts including John Schlegel, there is no guarantee that the group would stay put if the market starts to wobble further.

“If we’re headed for a more material market decline/eventual recession, then there could be room for positioning to fall further below the mid-June lows,” Schlegel and his colleagues wrote. “CTAs could get more short equities.” BLOOMBERG