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Don't Make the Same Mistake Hedge Funds Are Making

These hedge fund holdings look like hot potatoes

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May 26, 2022
Summary
  • Hedge funds' 13F filings from the 1st quarter reveal that the average hedge fund did preserve wealth for investors, resulting in a performance that was less bad than the S&P 500.
  • Unfortunately, hedge funds continue to make poor decisions about where to invest, in my opinion.
  • Despite their plummeting stock prices, the FAAMG stocks remained the top five most popular long positions among hedge funds.
  • On the other hand, hedge funds had an easier time with short-selling, so investors might consider following the so-called 'smart money' when it comes to shorting.
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The data from hedge funds' quarterly 13F filings is in, and the analysis of market performance against the stocks that most commonly appear among hedge fund positions has begun. The data reveals several interesting findings.

For example, the average hedge fund was down by only half as much as the S&P 500 for the first quarter, although the most popular hedge fund positions had plunged far more than the index. The outperformance despite top holdings doing badly ban be explained by the robust returns among smaller positions, as well as the the most popular hedge fund shorts. However, 13Fs do not report short positions, so we have to look to other sources for this data.

Additionally, while hedge funds have been trying to rotate out of plummeting growth stocks, they haven't been moving fast enough. In fact, the FAAMG names (Meta Platforms (

FB, Financial), Amazon (AMZN, Financial), Apple (AAPL, Financial), Microsoft (MSFT, Financial) and Alphabet (GOOG, Financial)(GOOGL, Financial) are still the most popular hedge fund positions, with Microsoft at number one. These are all stocks that I believe investors should avoid in the current market environment, but nevertheless, hedge funds remain unwisely invested.

Q1 by the numbers

According to Goldman Sachs' (

GS, Financial) latest Hedge Fund Trend Monitor, the average equity hedge fund was down 9% for the first quarter, with an estimated asset-weighted decline of 17%. Due to the ongoing struggles faced by equity hedge funds, most managers accelerated their reduction in leverage and rotation out of growth stocks, which they started several quarters ago.

However, despite the energy sector doing well, only four energy stocks entered Goldman's Very Important Positions list, which highlights the most popular long positions among hedge funds. Additionally, technology names still make up more than one third of the 50 stocks in the basket.

With the FAAMG names remaining at the top of the VIP basket, it has plunged 27% year to date compared to the S&P 500's 18% decline. Goldman's VIP basket underperformed the S&P 500 by 17 percentage points last year. Between early 2021 and the end of the first quarter, the VIPs have lagged the S&P by 28 percentage points, the worst stretch ever recorded. In fact, the VIPs have essentially given up all the excess returns they have generated since 2014.

However, hedge funds that hold short positions are keeping the equity strategy from getting completely killed. Goldman's most concentrated short positions are down 31% year to date. Unfortunately, all the flak that short-sellers have received since the meme stock frenzy in 2020 led many hedge funds to quit shorting, and it shows. Goldman Sachs found that short interest in the median S&P 500 stock remains low at only 1.5% of its market cap, the lowest level in 25 years.

Long/short equity hedge funds are bleeding capital

These numbers demonstrate that the years when stocks, mainly growth names, were the only game in town for yield-starved investors appear to be over. Suddenly, investors are rotating out of equities and into other asset classes, as evidenced by both household and institutional flows.

Macro concerns like skyrocketing inflation, positive real interest rates, growing recession concerns and plunging stock prices have shown investors that there's far more than equities when it comes to investing in search of yield and alpha.

As a result, equity hedge funds are not only feeling the burn of plummeting stock prices but also the sting of investor redemptions. According to With Intelligence, the hedge fund industry racked up $10.5 billion in net outflows month over month in April. The month marked a significant turnaround from the first quarter, when investors poured a net $18.1 billion into the hedge fund industry.

Over the last six months, investors have redeemed $30.9 billion from hedge funds compared to the previous six months. Unsurprisingly, long/short equity is the least popular strategy among investors, who have redeemed $6.8 billion from long/short equity hedge funds month over month.

Performance of popular hedge fund longs

Based on the market-wide rotation out of growth stocks and into value names, it's no surprise that energy, materials and utilities stocks were the best performers in the first quarter. According to Goldman's Hedge Fund Trend Monitor, shorts in health care, information technology and financials declined the most, supporting returns at long/short equity funds.

Interestingly, retail investors, who have regularly inflated the valuations of meme stocks at different times over the last two years, were significant sellers of the most concentrated shorts among hedge funds. The meme stock frenzy in 2020 and early 2021 resulted in massive short squeezes in many names, resulting in robust outperformance for popular shorts and taking a bite out of short-sellers' returns in the process.

However, starting in late 2021, flows among retail investors have reversed, corresponding with a reversal in the performance of hedge funds' favorite short positions. Goldman Sachs' trading desk estimates that retail investors have now sold most of the equities they bought over the last two years.

The firm's derivatives research analysts also estimate that retail investors have reversed more than half of the calls they had bought and the Nasdaq 100 stock positions they had built up since the pandemic began.

Rotations

The Hedge Fund Trend Monitor also showed a broad-based rotation out of information technology and consumer discretionary, where tilts now sit at their lowest levels in at least 10 years, and into energy, industrials and materials.

Hedge funds also rotated out of expensive stocks during the first quarter. Between 2009 and 2019, stocks with enterprise-value-to-sales ratios higher than 10 increased as a share of the equity market and as a share of hedge fund long positions.

The weights rose even higher in 2020 on the back of fiscal and monetary stimulus, which drove stock multiples higher and higher, especially on growth stocks. However, stocks with elevated multiples have since dramatically lagged the market. The hedge fund overweight in these pricey stocks has shrunk to its smallest size since 2014.

Here are the underperforming hedge fund favorites to avoid

While equities in general have lagged the broader markets, investors who tried to follow the so-called "smart money" by buying the most popular hedge fund holdings at the beginning of this year would be doing worse than many of those who try to pick their own stocks.

Usually, buying hedge funds' favorite stocks has worked well for retail investors, as this basket of the most popular longs has outperformed the S&P 500 in 58% of the quarters since 2001. However, the VIP basket has lagged the S&P 500 recently, returning -27% compared to the index's -17% return for the first quarter.

Thus, I believe investors would be wise to shift straategies. As already stated, the FAAMG names hold the top five places on the list of underperforming hedge fund favorites. More than 100 hedge funds still had Microsoft as a top 10 holding at the end of March. The software giant was down 24% for the first quarter and is now down by more than 28% through May 25.

Amazon declined 36% during the first quarter, while Alphabet was down 24%, Meta Platforms lost 43% and Apple plunged 22%. Over the last two months, it looks like most of the FAAMGA stocks are stopping the bleeding, with further declines since the first quarter ranging around 2% for most of them.

Hedge funds couldn't even pick new stocks during Q1

With all the declines in share prices among information technology and consumer discretionary companies, one might think that hedge funds would at least stop buying these two sectors.

Yet, information technology dominated the list of first-quarter hedge fund buys. Among the names with the greatest increases in popularity among hedge funds were Mandiant (

MNDT, Financial), Advanced Micro Devices (AMD, Financial), Workday (WDAY, Financial) and Accenture (ACN, Financial).

These stocks' returns show that hedge fund managers couldn't pick any new stocks to save their returns. The median return for the list of rising stars was -18% for the first quarter, and information technology stocks were among the worst performers, with declines between 23% and 40%. Mandiant was the sole IT stock on this list in the green with a return of 24% for the first quarter.

Popular shorts

There's no denying that the current macro environment is making it easier to find stocks worth shorting. The hedge funds that continued to sell stocks short despite the challenges they're facing from public opinion certainly did much better in the near-term. As a result, investors who like short-selling could take their cue from these popular hedge fund shorts.

Nvidia (

NVDA, Financial) was one of the largest short positions among hedge funds in the first quarter, and it has done well for short-sellers, plunging 42% year to date. Other profitable shorts include S&P Global (SPGI), which fell 30%, Pfizer (PFE), which declined 13%, and Bank of America (BAC), which was off 22%. Hedge funds also turned a profit off their shorts in Advanced Micro Devices, Home Depot (HD), Procter & Gamble (PG, Financial), Qualcomm (QCOM, Financial), Costco (COST, Financial), Adobe (ADBE, Financial), PayPal (PYPL, Financial) and Netflix (NFLX, Financial).

On the other hand, names like Exxon Mobil (XOM) turned out to be poor shorts. The oil giant's stock has soared 52% year to date, which is no surprise. Given skyrocketing oil prices, it's hard to imagine why hedge funds would short Exxon Mobil. In fact, it was the seventh most popular short listed by Goldman Sachs.

Final thoughts

Hedge funds have earned the right to be called "the smart money" over the decades by making wise decisions about where to invest. However, there will always be times when they don't know where to invest, and they are often hampered by their structures in ways individual investors are not subject to.

In such scenarios, I believe wise investors might want to avoid the most popular hedge fund stocks and look for under-the-radar names that have been outperforming.

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
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