According to the latest stats out for 4Q 2013, as revealed by our friends at the “Vampire Squid” aka Goldman Sachs, it seems that hedge fund managers en masse spent most of their time during the latter part of 2013 playing golf with their friends instead of trading their positions (or, ahem, mining their “expert networks”), seemingly feeling safe in the knowledge that the central bankers have their back and continue to manage risks for them (Ms “Yellanke” has stepped nicely into “Helicopter Ben’s” shoes).
According to the Squid’s calculations, total asset turnover by hedge funds in Q4 dropped by 28% to an all-time low with the major reduction actually occurring in the technology sector. We find this interesting given that the Nasdaq has powered ahead of other markets during the last 12 months as the chart below shows. It seems that the “momo” play is still in town – get long wildly and ludicrously overvalued stocks like TWTR, NFLX and FB and remain so while toasting QE at the country club! Of course, nothing lasts forever, not even diamonds, contrary to popular belief!
NASDAQ V DOW JONES
With the FED seemingly reassuring investors that the effective ZIRP (zero interest rate policy) seen in the US over the last 5 years is likely to remain in place for the foreseeable future, and with it continuing to pump equity values with freshly minted QE money, many hedge funds simply reason that they should continue to ride this trend and, with any leverage they can get their hands on. What this means in reality is that they are concentrating their positions in a few stocks that seem to run and run at the expense of diversifying risk. Great while it works. Disastrous when it breaks…
Of course, some funds specialise in certain sectors and so diversification across asset classes is not appropriate for these. That said, when taking account of the concentration seen across the whole hedge fund market, we still see the level of concentration that is materially in excess of historic norms. Currently, the typical hedge fund has an average of 63% of its long-equity assets invested in their top 10 holdings. That is a high concentration and which may pose a threat to returns whenever there is a change in the financial environment or there is a specific hit to one of their positions like what happened with Apple at the end of 2012 into early 2013.
The current 63% concentration of hedge funds compares with a figure of 31% for large-cap mutual funds and 22% for small-cap mutual funds. If you simply bought the S&P 500 or the Russell 2000 index trackers, the top concentration is 18% and 3% respectively and so you would be much better diversified.
So why are hedge fund managers putting all eggs in the same basket?
Why not is their likely retort?! Since the FED is managing equity downside risks (honestly!), hedge funds appear not to perceive any real threat to this stance and so, per conventional trading wisdom, they concentrate their positions in the momentum stocks. For the longer lived readers out there, you will know how this script ends, as very few fund managers have the personal discipline to jump off when the gains are outsized and indeed are able to judge the exit time well.
What does it mean for investors?
It means that many so called hedge funds are basically gambling with your money and when the market breaks (note – it always does) then unless you are really with a proper hedge fund manager, you will likely suffer outsized losses as the leverage and reversion to mean kicks in.
For many retail investors, the best strategy at an early stage of a bull market (of course you don’t recognise it as early stage at the time and this is precisely why it is) is to lever yourself by a modest amount on a major index and then steadily unwind as the market rallies. This way you have addressed diversification. Of course, like the so called “smart” money, people do the opposite – ratcheting up gearing as the market rises in the belief that they are invincible and the party goes on forever and which is why most money comes in near a top. In reverse, as the market gets ever more overbought you should do the same on the short side but temper your initial entry measure.
So, while the Fed continues to play the soothing violin music it seems all is well in the garden and we should continue inhaling the rose scented air. For the sceptics out there though, the move in gold seen this year together with the rout in certain of the emerging markets currencies which saw devaluations of upto 20% is symptomatic of the dangers this extended ultra-loose monetary policy is creating. What with the US Equity Schiller P/E ratio continuing to rise, this means that prices are growing faster than earnings. At some point prices and earnings will need to catch up and recent stats don’t leave us to believe it will be earnings.