Hedge Funds Have Been Shunning Momentum — To Their Peril

As the stock markets have plunged, hedge funds have done the only thing they could do to protect themselves. Overall, funds remain in a holding pattern—with their lowest exposure to equities since 2009. That’s undoubtedly good news for investors, as the top 50 most popular long positions among hedge funds have plummeted year to date. However, funds have also become anti-momentum, which has damaged their returns.

Hedge funds limit equity exposure

In its quarterly Hedge Fund Trend Monitor, Goldman Sachs reported that the average hedge fund is down 5% year to date amid a challenging market for both alpha and beta. Light exposure has helped hedge funds limit the beta headwinds caused by the S&P 500’s 16% year-to-date decline and the 29% decline for Goldman’s Hedge Fund VIP basket of the 50 most popular long positions among fundamental hedge funds.

The firm added that macro funds have generally performed better than equity funds, returning 9% year to date versus the average equity fund’s return of -12%.

Quarterly position turnover among funds fell to a new low during the third quarter. The firm noted that the total magnitude of changes to sector tilts was also the smallest since 2019 and that most tilts are around their 10-year averages.

Factor tilts

Goldman also reported that the balance between growth and value returned to its 20-year average, adding that funds are usually tilted toward growth. However, they’ve been carrying more exposure to value than usual over the last year.

The outperformance of growth during the third quarter helped shift the hedge fund tilt back to its 20-year average of growth versus value. Additionally, despite their light market exposures, hedge funds’ long portfolios have an unusually large tilt away from momentum.

Over the last 20 years, the only other time the current anti-momentum tilt was exceeded was in early 2002 and the second quarter of 2022. Hedge funds usually tilt toward momentum, but they’ve been gradually reducing that positioning since mid-2020.

Goldman also noted that momentum has recently been extremely negatively correlated with the direction of the equity market, as demonstrated by the sharp reversal alongside the market rebound early this month.

As such, it makes sense that the tilt away from momentum served as a headwind for fund returns for most of this year, although it was rewarded this month during the sharp momentum reversal. Goldman’s long/ short S&P 500 Momentum factor has returned 20% this year through Nov. 3, but since then, it has reversed sharply, with the reversal ranking in the first percentile since 1980.

The firm reported that momentum has outperformed during other periods of market stress, including 2009, 2012, 2016 and 2020. Thus, Goldman doesn’t expect momentum to fully unwind its recent outperformance without substantial improvements in the market and economic outlooks.

Falling net leverage

Meanwhile, net leverage continued to trend lower, just as it has throughout the year. However, the firm added that gross exposures are still surprisingly high, given the challenge of picking winning stocks in the current environment.

Although net leverage has ticked higher over the last month, it remains far below its one- and five-year averages. Gross leverage has been volatile but declined much less. Light net leverage suggests hedge funds aren’t optimistic about the market’s near-term trajectory, but their tilt away from momentum seems to conflict with that view.

Funds used ETFs and futures to manage their exposures to the macro-driven, highly correlated market. The ratio of ETF to single-stock short interest is now up to its highest level in 10 years. In fact, short interest in single stocks remains near the record lows reached in 2000 and last year.

The Hedge Fund VIP list

Although Goldman’s Hedge Fund VIP basket has plunged 29% year to date, hedge funds appear to be convicted on their favorite stocks. The average hedge fund has 71% of its long portfolio invested in its top 10 positions, the second-highest concentration after the fourth quarter of 2018.

Technology and communication services make up almost half of Goldman’s VIP list and eight of the top 10 stocks. Although hedge funds paused their shift away from Chinese ADRs during the third quarter, Alibaba remains the only representative on the VIP list.

The VIP basket has outperformed the S&P 500 in 58% of quarters since 2001, generating an average excess return of 34 basis points per quarter. However, the basket has underperformed this year, losing 29% year to date and lagging the S&P 500 by 13 percentage points.

This year’s performance also puts the VIP list on track to have its second-worst year over the last 20 years in absolute terms after 2008 and relative terms after 2021. The VIP list has lagged since early 2021, although it outperformed the market in the third quarter. However, the basket has since resumed its underperformance over the last several weeks.

Minimal sector shifts

Sector allocations were relatively stable during the third quarter as most of the net sector tilts sat in the middle of their distributions over the last 10 years. Interestingly, the firm noted that the largest sector shift was a rotation from consumer discretionary to consumer staples. However, four of the top 10 names on the VIP list of the most popular hedge fund stocks are consumer discretionary names.

Industrials is still the largest net overweight relative to the Russell 3000. However, just one stock, TransUnion
TRU
, landed a spot on the firm’s Rising Stars list of the stocks with the largest increase in popularity among hedge funds during the third quarter. Meanwhile, four industrials names were on Goldman’s list of Falling Stars: GXO Logistics, Robert Half International
RHI
, Johnson Controls International
JCI
, and IAA.

Here’s what’s on the VIP list for Q3

In addition to the tilt away from momentum, there was a recent tilt away from quality factors in Hedge Fund VIP list, including high returns on capital and low volatility. The firm added that the performance of their most popular longs has been particularly correlated with small-cap outperformance rather than large caps.

Microsoft
MSFT
replaced Amazon
AMZN
as the top stock among hedge funds, and Uber
UBER
and Netflix
NFLX
rose on the list to enter the top five. Meta Platforms tumbled to fall out of the top five for the first time since 2014. There were 15 new additions to the VIP list in the third quarter, including NVIDIA
NVDA

DIA
, Workday, VMware
VMW
, S&P Global, Liberty Media Series C, and Eli Lily.

In addition to Microsoft, Amazon, Meta Platforms, Uber and Netflix, the other top 10 stocks were Alphabet, Visa
V
, Apple
AAPL
, Mastercard
MA
and PayPal
PYPL
. All of the top 10 positions are in the red year to date, with Meta Platforms (-65%), PayPal (-52%), Netflix (-49%), and Amazon (-41%) being the worst performers. Only Visa (-2) and Mastercard (-4%) have posted single-digit negative returns.

Looking further down the list, T-Mobile (+25%), Willscot Mobile Mini Holdings (+14%), and Activision Blizzard
ATVI
(+12%) were relative outperformers compared to the rest of the list. Some particularly strong performers included Chesapeake Energy
CHK
(+71), Energy Transfer LP Unit (+58%), and Eli Lily (+30%). However, they were pretty far down on the list of VIPs, suggesting they are far less popular than numerous positions that have plummeted this year.