Why hedge funds are still searching for the next big thing
Today’s liquidity-drenched markets make it much harder to pick winners
Stock markets are not making life easy for hedge funds. The discomfort looks likely to continue for some time.
January had been shaping up quite nicely for equity-focused managers until a widespread market sell-off, sparked by the coronavirus outbreak, eroded much of their gains. Such funds were up just 0.2 per cent to Tuesday, according to data group HFR.
Managers find themselves in a dilemma. In runaway market rallies such as this one, they feel investors give them little credit for picking out overvalued stocks. To a much greater extent than in previous bull runs, share prices are often supported by central bank stimulus. That keeps borrowing costs low, sustaining risky business models.
But bear markets present dangers too. Managers can be lured into taking on too many bets on rising stocks, particularly if the good times last as long as they have, only to find they offer investors little protection when share indices fall. This happened in 2018 when hedge funds underperformed in a falling market.
The same may have happened this month: equity hedge funds’ net bets on rising stocks — after subtracting “short” positions, where they bet on prices falling — were running close to their highest levels of the previous 12 months, according to Goldman Sachs.
At the heart of the problem is a lack of strong trading themes, which throw up stocks to short. Unlike the dotcom bust of the early 2000s, which offered a perfect opportunity to bet on falling tech stocks, or the subprime crisis — targeted by a smart few — attractive short trades have been few and far between.
The demise of the high street retail sector has offered some opportunities, and the UK’s exit from the EU on Friday might do so too, although Brexit has so far been a frustrating trade for hedge funds.
But in general, trying to find profitable shorts has been hard going. Lansdowne Partners, one of Europe’s biggest hedge funds, told investors in its European Absolute Opportunities fund this month that its top 10 losing positions last year had all been short bets, according to a letter seen by the Financial Times. Investors have been voting with their feet. Last year they pulled $22.4bn out of equity hedge funds, according to HFR.
More worryingly for the sector, some investors may be pulling out because they do not trust managers to protect them in a downturn. Investors are “scaling back” from traditional long-short funds, said Anthony Todd, chief executive of Aspect Capital, a computer-driven hedge fund that follows market momentum.
There will be good reasons to have money in hedge funds when the next bear market comes. But, as long as assets are pumped up by central bank stimulus, investors will continue to question why they should pay hedge funds’ steep fees when they can get much better returns from a cheap tracker.