(Bloomberg) -- As stocks whipsawed over the past week, hedge funds took a stance that’s hard to frame as bullish, intensifying bets against the market and limited long positions to a shrinking group of companies.
The ratio of hedge funds’ long to short positions, known as net leverage, sank to the lowest level since February 2016, data compiled by Morgan Stanley’s prime brokerage unit showed. At the same time, gross leverage, a gauge of risk appetite that adds up both long and short positions, remained above the 75th percentile since 2010.
So while hedge fund stock exposure remains elevated, the bulk of the positions are short. Meanwhile, long positions among the funds have become concentrated in a few names, giving rise to a level of crowding that breeds concern about a mass exodus.
High gross leverage “is a risk when everyone is on the same side of the same trade,” said Benjamin Dunn, president at Alpha Theory Advisors LLC. The low net “is telling you that managers are concerned about the near-term direction of the market,” he added. “The outlook over the next six months has certainly become a lot cloudier.”
Stocks suffered the biggest loss of the year Monday as a trade war with China escalated just days after Federal Reserve Chairman Jerome Powell played down his easing cycle. The index eked out a second straight gain Wednesday, but remains 5% below its all-time high reached in July.
The broad rise in short positions and concentrated nature of longs has pushed the spread between gross and net leverage to a five-year high. As the selling intensified earlier in the week, rather than buying the dip, Morgan Stanley’s hedge fund clients doubled down on bearish wagers. They added shorts and boosted hedges through put options, extending their year-long mistrust of the stock market.
At the same time, the smart money crowd’s faith in individual stock picks is strengthening. Software and biotech shares remain the most popular target, while commodity and financial stocks are liked least.
A similar phenomenon is occurring among hedge funds tracked by Credit Suisse, where the firm found clients are holding the same stocks to an extent never seen before.
Long-short funds “have chosen a more selective approach, reducing overall exposure around a core group of secular longs, increasing concentration,” said Mark Connors, global head of risk advisory at Credit Suisse.
To be sure, having a big short position can amplify rallies when the market turns since higher prices force bears to buy back shares to avoid bigger losses. But that’s not happening now. Rather, JPMorgan Chase & Co. clients took advantage of last week’s carnage to snap up shares and return borrowed stocks, an action known as short covering.
The latest rout showed no signs of panic and fund managers are comfortable picking stocks when shares aren’t moving in lockstep, according to Chaya Slain, chief investment officer of Cleveland-based family office AdCap Management.
“When markets become irrational, you get indiscriminate selling so you want to reduce gross and net leverage,” Slain said. “I am not surprised by this as long-short managers have finally started to do well and as they get more confident, they increase leverage. This is a change from recent history as stocks were highly correlated and moving together.”
Stock-picking conviction paid off during the last market sell-off. In May, when the S&P 500 tumbled, hedge funds’ top 50 longs beat the market while their top 50 shorts sank more, bolstering fund performance.
This time, hedge funds haven’t fared as well. Their favorite stocks have trailed the S&P 500 by about 0.6 percentage points this month while the hated shares performed in line with the market, Morgan Stanley data showed. With overall books extended, money managers are likely to resist buying on weakness, the firm says.
“Perhaps the bigger risk right now is that high gross leverage limits the ability of funds to step in and buy the dip,” Morgan Stanley wrote in the note to clients Tuesday. “A shift towards de-grossing could have negative repercussions on crowded returns.”
(Updates with investor comment in 11th paragraph.)
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