Published by Bob Elliott on March 20, 2023 9:30:09 AM
Hedge Funds have experienced some of their worst performance ever over the last couple weeks. March performance is estimated down roughly 3%, with most of that loss having accrued last week. This magnitude of losses over this time frame is not unheard of – it seems to happen every couple years or so – but it has been unusual to see such weak performance from Hedge Funds at a time when traditional portfolios have been pretty stable.
Nearly every hedge fund position tilt has underperformed. Hedge funds came into the period underweight bonds, growth stocks, large caps, and domestic stocks on a relative basis. While many of those bets were previously performing, nearly all of them reversed course as the stress on Silicon Valley Bank and Credit Suisse emerged. The magnitude of the underperformance of these crowded trades suggests that a meaningful driver has been Hedge Funds themselves rapidly de-grossing their books in response to elevated uncertainty and counterparty risks. While these positions have underperformed, there may be an end in sight once managers get closer to desired risk targets and pricing shifts to offer improved alpha opportunities.
The chart below contextualizes last week’s drawdown. The initial estimate of performance shows Hedge Funds down almost 3% on the week.
Source: HFR and Unlimited calculations. The results depicted are aggregated results, are not indicative of future results, and do not represent returns that an investor attained.
While a loss of that size feels considerable, it is a reasonably common occurrence. The chart below shows a histogram of rolling 5 day Hedge Fund performance since 2003. This magnitude of weakness happens about 1% of the time, or about 1 week every few years.
Source: HFR and Unlimited calculations.
Hedge funds came into the period positioned for a continuation of the late cycle dynamics that had been in place for many months. Funds were considerably underweight duration as macro funds in particular put on large bets expecting rates to continue to rise relative to what was priced in. They were also underweight equity risk coming into the period.
Source: HFR, Barclayhedge, Credit Suisse, Bloomberg, and Unlimited calculations.
What equity risk they held was also conservatively positioned. Funds were underweight growth stocks, large stocks, and US stocks relative to the rest of the world.
Source: HFR, Barclayhedge, Credit Suisse, Bloomberg, and Unlimited calculations.
As the SVB issues emerged, the majority of these position tilts underperformed. The most significant was macro funds’ short positions in the 2yr interest rate. Rates on 2 year bonds fell more last week than during any period since the ‘87 crash. This suggests that funds may themselves have been caught in a short-squeeze dynamic, and had margin called on their positions, which exacerbated the declines in rates.
Source: FRED and Unlimited calculations.
Trend following approaches also experienced an underwhelming period as well with the CTA index experiencing its worst week of performance in 25 years. Many of these funds were positioned for a continuation of the inflationary, late cycle tightening of monetary policy. The deflationary risk from a banking crisis quickly drove a shift in fundamental conditions and increased market action, which caught many of these funds offside. Part of what exacerbated the moves was funds adjusted their positioning in response to extreme counter-trend market action.
Source: Barclayhedge and Unlimited calculations.
Stock picking funds also appear to have experienced a short squeeze dynamic. Nearly all the major tilts these funds held underperformed last week. The breadth (many of which were unrelated to each other or counterintuitive) suggests de-grossing may have been a meaningful driver.
Funds came into the period significantly underweight growth stocks. But even as financial risk rose, growth stocks outperformed significantly.
Source: Yahoo Finance.
Many funds were short the tech sector specifically. Those stocks experienced some of the strongest performance in the market last week.
Source: Yahoo Finance.
Funds came into the period overweight foreign stocks relative to US stocks, positions which saw similar underperformance last week. The unusual outcome of a banking crisis in the US resulting in US stock outperformance suggests de-grossing likely played a role.
Source: Yahoo Finance.
Finally, small caps in particular underperformed during the period relative to large caps. Many funds entered the period underweight large companies given their relatively high comparative valuations. The significant underperformance of smaller companies, the majority of which were unrelated to regional banks, suggests influences apart from views on relative fundamentals.
Source: Yahoo Finance.
While it has been a rough couple weeks for Hedge Funds, there may be some relief in sight. The significant recent de-grossing by funds brought VaR – a measure of risk – from already low levels to their lowest outside of the COVID crisis and ’08 periods. As the pace of de-risking slows, there could be less pressure on the crowded Hedge Fund positions discussed above.
Those positions still appear to have strong fundamental underpinnings that seem slightly more attractive as markets have priced in a relatively catastrophic deflationary crisis and sector diffs have widened further. While there is never any certainty about how things will play out, there appears to be opportunity for Hedge Funds to generate differentiated returns ahead.
Source: HFR, Barclayhedge, Credit Suisse, Bloomberg, and Unlimited calculations.
For decades, Hedge Fund strategies have demonstrated the ability to outperform index investing, and it seems reasonable to expect that to continue given the resources these funds invest into generating alpha. By their nature, most funds derive their returns by seeing corporate or economic environment trends ahead of others and positioning advantageously. Investors that have followed Hedge Funds over time have seen the output of that strategy. But there are some times, like we have recently experienced, when trends abruptly reverse for whatever reason (COVID, bank crisis, etc.) and crowded positions are squeezed resulting in underperformance. For investors, the tradeoff is going through these periods of underperformance to gain access to alpha generation.
For informational and educational purposes only and should not be construed as investment advice. It does not constitute an offer to sell or a solicitation of an offer to buy any security. Opinions expressed are our present opinions only. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein. This material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages.