Skeptical of US equities, equity hedge funds stay away from market rally

Still uncertain about the direction of U.S. equities, equity hedge funds remain on the sidelines of the market rally despite large paper losses on bearish bets since June, according to industry executives and data from the market.

After falling more than 20% in the first half on fears that the US Federal Reserve’s aggressive rate hikes aimed at controlling inflation could trigger a recession, the S&P index has rebounded 17% since the mid-June on signs of price stabilization.

However, hedge funds sat on the sidelines of the rally to assess more economic indicators before recalibrating their portfolios, prime brokerage executives and fund managers said.

In a sign of their poor market view, hedge funds are sitting on a record $107 billion in net short positions – or negative market bets – in S&P 500 futures, according to BNP Paribas calculations based on regulatory data from last week.

This skepticism among sophisticated investors with $1.1 trillion in assets worldwide suggests the rally could be short-lived, according to major brokerages.

“This is probably one of the most hated rallies in the market across all client segments,” said a senior broker at a Wall Street bank, noting that funds sold long positions in the rally. “The first week of August was one of our biggest harm reduction weeks we’ve seen in the past five years.”

Stocks are rallying largely because some investors believe the Fed will back off from tightening monetary policy sooner than expected, although Fed officials are not making that promise.

Not all bearish hedge funds have been able to sustain their short positions, and some of the market’s recent gains have likely been fueled by investors unwinding or “hedging” these bearish bets, the people said. This process involves buying back shares that the funds had borrowed to sell short.

NOT A GREAT SIGN

“There was a lot of hedging by hedge funds as the market rose,” said Kris Kwait, chief market strategist at Commonfund, an asset manager that invests in hedge funds.

Kwait added that the fact that hedge fund hedging appeared to be driving the rally was “not a good sign” for its sustainability.

When the rally accelerated in July, hedge fund sales of long positions and purchases to cover short positions in consumer discretionary stocks, for example, were among the largest in the past five years, according to data from Goldman Sachs.

Max Grinacoff, U.S. equity and derivatives strategist at BNP Paribas, said short hedging continued in August, and last week “in particular,” after Wednesday’s Consumer Price Index data suggesting that inflation may have peaked drove stocks higher.

Since June 16, short sellers have suffered unrealized losses of $174 billion, although they have increased by another $162 billion in unrealized gains this year, according to financial analyst firm S3 Partners.

The equity positioning of institutional investors as a whole has increased in recent weeks, but has remained in the 15th percentile of its range since January 2010, meaning it has only been lower 15% of the time over the past 12 years, according to an August 13 report. note from Deutsche Bank analysts.

Against a backdrop of macroeconomic uncertainty, hedge funds have significantly reduced their overall risk this year. The net leverage of long-short equity hedge funds was 48% at the end of July compared to almost 70% in January, according to a report by Goldman Sachs.

Hedge fund portfolio managers are likely to reassess their strategies next month when liquidity is expected to increase after the summer holidays end and more economic data becomes available, two prime brokerage executives said.

“Investors could still be bearish on the overall outlook,” BNP Paribas’ Grinacoff said. “But to the extent that they get caught offside, they may have to cover or potentially enter the rally upside down.”

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