Hedge Funds Are Sticking to Time-Tested Blueprint for a Rattled Stock Market

(Bloomberg) -- The minute-to-minute news cycle inaugurated two Sundays ago with President Donald Trump’s trade salvos hasn’t chased hedge funds from the market. But it has prompted them to redouble defensive measures.

Gross leverage, a measure of industry risk appetite, rose last week to the highest level since early October as hedge funds boosted bets against stocks through vehicles such as index options, data compiled by Morgan Stanley’s prime brokerage unit showed. At Goldman Sachs, fund clients increased short sales through exchange-traded funds while snapping up single stocks.

They “took up their hedges through the usage of macro products” such as ETFs, Goldman wrote in a note to clients. “There was no significant deleveraging or panic selling.”

It’s a familiar pattern. For months, as equities rallied, hedge funds have stuck to a cautious stance, keeping equity exposure below its historic average. With the S&P 500 heading for its first monthly loss this year, the carnage is starting to look like validation for their stubbornness. A similar plot played out in the second half of last year, with hedges paying off when the S&P 500 plunged to the brink of a bear market.

With the benchmark down 4% from its April peak, hedge funds are gearing up for more losses and they’re doing it mostly through macro bets. Among funds tracked by Goldman, the amount of ETFs sold short jumped 5.8% last week, led by those focused on large-caps and semiconductor stocks, the firm said. That’s the biggest increase in about two months.

Traders also flocked to index options for broad market hedges. The demand was so strong that index puts spiked last Tuesday relative to their overall short positions at a rate that’s almost three standard deviations above the average reading that Morgan Stanley has observed since 2010.

Meanwhile, hedge funds took advantage of the decline to add individual companies. Their net buying on single stocks outpaced selling by 1.6-to-1 last week, data from Goldman showed.

Better performance by their favorite stocks may have added to confidence in their picking skills. A Morgan Stanley index tracking the industry’s most crowded longs versus shorts has gained almost 1% this month. With protections in place against a market meltdown, a bigger threat could come from any unfavorable shift among industries or stocks, the firm said.

“The larger risk for HFs at this point could be rotational in nature, rather than losses simply due to being net long the market,” Morgan Stanley wrote in a note to clients.

To Charlie McElligott, a cross-asset strategist at Nomura, the recent building of shorts means the market could get a relief rally should hedge funds start to cover.

“This now is where I expect said next wave of monetization in hedges -- especially into the enormous fodder of fresh shorts (index, ETF and single-name equities) which have been piled-into over the past week and half, to stabilize and create an ‘optical’ market bounce over the coming days,” he wrote in a note to clients.

To contact the reporters on this story: Lu Wang in New York at lwang8@bloomberg.net;Melissa Karsh in New York at mkarsh@bloomberg.net

To contact the editors responsible for this story: Brad Olesen at bolesen3@bloomberg.net, Chris Nagi, Richard Richtmyer

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