Mo' Momo, Mo' Worries - Quants Fear Hedge Funds' "Outsized Exposure" To Market Momentum

Better lucky that smart? Managers of active funds are now extremely concentrated in the strongest parts of the US equity market with "momentum" massively outperforming the market in August (and ramping higher off the North Korea missile launch lows).

Bloomberg"s Dani Burger notes that with more than half of their bets on high flyers like technology and online retailers, hedge funds have near-record exposure to momentum trades, a strategy that’s up 2.6 percent in August even as the S&P 500 heads for its worst month since the election. The resiliency of the bet was on display Tuesday, when Alphabet and Amazon opened nearly 1% lower before rebounding along with Apple to deliver the S&P 500’s biggest intraday reversal in 10 months.

“It’s like these things are like gold -- it’s almost like a safe haven,” said Mark Connors, the global head of risk advisory at Credit Suisse Group AG.

“This resilient price action in equities is commensurate with the constructive positioning we see across hedge fund strategies and speaks to the persistent positive sentiment in 2017.”

The much-followed FANG Stocks soared over 2.1% off the opening lows...

The 50 most popular hedge fund longs...

Bloomberg"s Burger asks, how long can it last?

That"s a question that’s becoming more urgent for hedge funds that have finally caught up to a market where gains are delivered by an ever-narrowing cohort of stocks. Volatility has been rising amid renewed geopolitical tensions, signs of uneven economic growth in the U.S. and the threat of further interest-rate hikes by the Federal Reserve.

What’s more, the very nature of following momentum poses its own pitfalls. The strategy is one of the more volatile factors, and when rotations occur, pain seeps through as leaders quickly move to the back of the pack.

All that points to a hedge fund love affair that’s headed for heartbreak, according to Joseph Mezrich, head of U.S. quantitative analysis at Nomura Instinet LLC.

“We are concerned about this outsized exposure,” Mezrich, wrote in a note to clients. “The last time momentum exposure was this high was in 2013-2014, which led to a sharp decline in fund performance when momentum collapsed. Fund managers may be setting themselves up for a repeat.”

So what happens next? We leave to CS" Mark Connors...

"You can’t manage your book for a big deleveraging... Momentum is an escalator up and an elevator shaft on the way down. But managing that is what active managers do for a living.”

The Simplest Reason Behind Collapsing Volatility: Hedge Funds Are Barely Trading

"Gamma", "vega", CTAs, risk-parity, vol-neutral, central bank vol-suppression, the soaring popularity of (inverse) VIX ETFs , and so on: over the past year there have been countless attempts to explain why despite the surging political uncertainty in recent years, and especially since the US election...

... global equity volatility, both implied and realized, has tumbled to record lows, sliding even below levels not even seen before the 2008 financial crisis.

There may be a much simpler reason.

In its latest hedge fund tracker report, which every quarter analyzes the 13F filings by US hedge funds, Goldman found something quite striking. When looking at the gross portfolio turnover of hedge funds in Q1, the bank found that it had retreated to a record low at 28% of positions in 1Q 2017.

At the same time, turnover of the largest quartile of hedge fund positions, which account for two-thirds of hedge fund long holdings, fell to 15%, close to its lowest level since 2002. As a result the typical hedge fund has 67% of its long equity assets invested in its 10 largest positions, a decline from last quarter but still near historical highs.

This suggests that in the first quarter, hedge funds found themselves even further "paralyzed", and for whatever reason have reduced overall trading levels to all time lows. This further suggests that with virtually no trading by the "smart money", those traditionally most likely to put on "volatile" positions, contrary to consensus, the bulk of executed trading took place among passive funds and other trend followers, which would facilitate and accelerate the ongoing decline in volatility.

Stated simply: volatility has collapsed for the simple reason that increasingly fewer directional, non-momentum chasing market participants are actually trading.

But if hedge fund turnover has collapsed, how do these "active managers" hope to generate alpha? One explanation is that in lieu of stock picking, hedge funds have simply lifted leverage to post-crisis highs as their most popular long positions outperformed in a rising equity market. The Goldman Sachs Prime Services Weekly shows that, after bottoming in mid-2016, hedge fund net and gross exposures have continued to rise. Net exposure (73%) is now roughly in line with its cycle highs reached in 2013, while gross leverage (234%) has soared to new post-crisis highs.

This dynamic has contributed to a virtuous cycle as our Hedge Fund VIP basket of the most popular hedge fund long positions rallied, outperforming the S&P 500 by 360 bp YTD (10.1% vs. 6.5%).

And while such dramatic concentration among the top positions has been observed before, most recently yesterday when we showed the fresh collapse in market breadth vs the once again resilient "broader" market...

... this bring up another key concern: with the bulk of hedge funds holding just a handful of names - mostly tech stocks comprising the so-called FAANG, which as a group have returned nearly 30% and are responsible for half of the S&P YTD gains - proppeled to record highs by a fresh burst of momentum chasing, what happens when for whatever reason, this trade is unwound.

This is Goldman"s take:

The rise in leverage alongside growing popularity of outperforming growth stocks has raised some concerns among clients, even while boosting their portfolios. Investors recall the sharp momentum reversal of early 2016, which came on the heels of a similar period of rising popularity and performance for “FANG” (FB, AMZN, NFLX, GOOGL) and similar stocks in late 2015.

Indeed, investors have reason to be concerned: for a vivid example of what happens when such "hedge fund" hotel trades go into reverse, look no further than Valeant...