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Hedge Funds Trail 2019 Rally Despite Decade’s Best Stock Picking

Hedge Funds Trail 2019 Rally Despite Decade’s Best Stock Picking

(Bloomberg) --

Hedge-fund managers showed their best stock-picking skills of the decade in 2019. But it still wasn’t enough to turn around a lackluster performance.

Equity long-short funds saw their stock alpha, or above-market returns, rise to 13% last year -- the most since 2010, according to prime brokerage data compiled by Morgan Stanley. Their overall fund gains, however, averaged 15%, well short of the S&P 500’s total advance of 31%, while other data providers showed even lower performance for the industry.

Hedge Funds Trail 2019 Rally Despite Decade’s Best Stock Picking

How is it possible that smarter company picks didn’t translate into better returns? One factor was the lofty fees that hedge funds charge their clients eating into the gains, according to Morgan Stanley. The industry’s reluctance to chase the rally was no help either. While individual stocks worked in their favor, holdings in equity products that include index futures and exchange-trade funds showed persistent skepticism, the bank’s data showed.

Net leverage, a measure used to track hedge funds’ bullish versus bearish positions relative to the whole book, averaged 46% last year. That’s tied with 2016’s reading as the lowest over the decade and compared with an average of 51%.

“Given this, funds were not able to capture as much of the market gains as they would have if they maintained higher nets,” Morgan Stanley wrote in the note to clients Thursday.

Individual company picks boosted returns for hedge funds in all but one month last year, the firm’s data showed. Real-estate and health-care stocks provided the best alpha, with their favorite longs beating their bearish bets by at least 27 percentage points.

Still, a lack of faith in the gains overshadowed the stock-picking success. Coming off late 2018’s near-death experience when the S&P 500 tumbled to the brink of a bear market, hedge funds began 2019 with the lowest exposure in years and had resisted chasing the rally until the final few months.

Hedge Funds Trail 2019 Rally Despite Decade’s Best Stock Picking

Fund managers scooped up ETFs and index futures during the fourth quarter, sparking a surge in the equity tilt among Morgan Stanley’s global fund clients. Over the three months, a measure of their long-versus-short positions jumped to almost the top decile of a 10-year range from the bottom.

While the risk-on move helped money managers keep pace with the market, it was too late to turn things around. Equity funds tracked by Hedge Fund Research trailed the S&P 500 by almost 18 percentage points in 2019, the second-worst year of relative performance since 1990.

A more pressing question now is whether positioning has become overextended, making the market vulnerable to an exodus of money. Such worry is premature to Morgan Stanley. While widespread optimism in mid-2015 and early 2018 preceded market weakness, the firm found that sentiment now is far from unanimous. For instance, net leverage among European and U.S. long-short funds still sit below their historical average.

“To some extent, this might mitigate the risk that a wider array of investors would need to sell in the event of a pullback,” Morgan Stanley wrote. “Our general view is that positioning has certainly ramped up a lot, but it’s not clear that all signs point to ‘euphoria.”’

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, Richard Richtmyer, Rita Nazareth

©2020 Bloomberg L.P.