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Equity long-short hedge funds have had a miserable decade both in terms of performance and flows. MainFT last week published a very good piece on the theme.
But in one small but important respect, things seem to be looking a little brighter. In a note titled “Hedge fund nirvana” Credit Suisse UBS quant Patrick Palfrey notes how heavily shorted stocks have started to do badly this year.
This could represent a shift to a slightly more hospitable climate for L/S hedge funds, whose shorts have generally been a grisly mess over the past decade, he argues:
Macro Matters for Hedge Funds
Regardless of how much long/short managers might attempt to mitigate macro risk, there are environments that are simply more/less conducive to their process. The YTD underperformance of highly shorted stocks relative to less shorted names is a particularly favorable backdrop for hedge funds, and one likely to persist as long as economic reports remain robust.Market Rotates on Fed Rate Cut Expectations
In the last 2 months of 2023, the number of expected rate cuts increased from 3 to 7. It has since fallen to 4½. While the S&P 500 has advanced steadily since October 27 (+22.1%), stock leadership has flipped 180° since the start of the year on shifting Fed policy forecasts. This reversal is most evident in small cap and economically-sensitive companies, which outperformed in late 2023, but have fallen out of favor since.Hedge Fund Shorts Working as Fed Cut Expectations Decline
From late October through the end of 2023, highly shorted companies outperformed their peers, a challenging environment for hedge fund managers. However, this trend reversed at the start of 2024 — coinciding with a shift in expected cuts — providing a more supportive backdrop. Importantly, this trend is in place across size and sectors.
Goldman Sachs’ “Very Important Shorts” index of the biggest negative hedge fund bets also indicates a notable relative underperformance of popular shorts (albeit it suggests it started last year).
But perhaps more importantly — given that most L/S funds actually have a clear long bias — its “Hedge Fund VIP” index of the chunkiest long positions has performed strongly. It’s up 8 per cent already this year.
That popular shorts are still in positive territory means that “hedge fund nirvana” is a tad overdone — on average they’re just not losing as much money as before — but at least things are looking a bit less bad for long-short hedge funds right now.
Another short-selling aspect that often gets forgotten is how higher interest rates also help L/S hedge fund returns by increasing their cash returns.
Ie, when you borrow a stock and sell it, you’re sitting on cash. For most of the post-08 period that yielded next to nothing — and possibly explained at least some of the downgraded performance of L/S funds — but now a hedge fund treasurer can easily generate 4-5 per cent on that cash.
Goldman estimates that the median short interest in S&P 500 companies is still remarkably low at 1.7 per cent, but is up from 1.5 per cent at the end of 2021.
Maybe Jim Chanos closing his hedge fund last November marked the nadir of short selling?