Hedge Funds Bet the House on Equities after yet another year of underperformance

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It was reported earlier this week that hedge funds as a group have materially ratcheted up their borrowing levels, primarily to trade equities. “Margin” loans extended by NYSE brokers to their clients reached the highest in four years whilst leverage amongst hedge fund managers who speculate on share prices climbed to levels not seen since the beginning of 2004. Gross leverage, a measure often used to give an idea on how leveraged a fund is, is currently estimated to be around 153%, after averaging 143% since 2005. This means that across the sector, on average a hedge fund is exposing itself to 153% of equities relative to the deposits from clients. Usually the gross margin moves in tandem with the S&P 500, as fund managers are more willing to increase their bets at times the market is rising. Ominously, historically, when the margin has reached such levels, a market breakdown has typically been shortly around the corner…

Strangest bull market in history

With the FED continuing to buy $85 billion in government bonds and mortgage-backed securities each & every month, depressing yields to historical low levels in the process, it seems that there is no other option left for individuals and money managers other than to desperately chase bet and invest incrementally in equities. It seems that being bullish is a consequence rather than a real feeling about market prospects. This is a dangerous situation in our opinion and has been brought about by the “strangest bull market in recent years” in which very few investors have actually participated.

Only last week we wrote about the fact that after 4 years of a strong bull market (albeit punctuated with some stomach churning shakedowns like the so called “flash crash”), with share prices doubling in the US and up nearly 60% in the UK, retail investors in the last 2 months decided to actually be net buyers of equities (as opposed to sellers). This is another contrarian warning sign, although this is tempered by the fact that there is so much “parked” money in so called “safe funds” like bonds and money market funds that should this trend persist, then this momentum alone could carry equities to new highs.

Alpha continues to elude the industry

For the hedge funds, given that they averaged as a group, a return of just 1.3% last year, they don’t really have much choice than to increase exposure to the market rally. Many hedge funds were in fact closed last year due to continuing underperformance relative to their benchmarks and the remaining need to desperately seek for the missing alpha that has eluded so many for so long (not least Mr Paulson!).

The latest US economic data has been moderately positive in recent months. Unemployment continues to fall, GDP is growing, corporate profits are rising, as is industrial production and the housing sector’s recovery gathers pace. But, all these positives are just moderately positive and the debt ceiling issue looms ever nearer as we blogged about earlier. If you look at the table below which records the performance for several equity indexes around the world, you will see that there isn’t a single one with negative returns since Dec. 28. Italian and Spanish equities lead the table as they continue their recovery from very depressed levels – hardly a situation that can be applied to the US markets. To us, US equities in particular are now approaching “speculative” levels that do not discount potential debt ceiling problems.

This first quarter of the year will likely be a tough period from  corporate earnings perspective, even though so far companies are beating analysts’ estimates and they probably will continue on that trend, but the estimated overall growth rate for Q4 12 earnings to be reported over the next few weeks is just a tad above 1%. Technology companies are expected to report awful results as IT spending decreased due to European problems and also US uncertainty regarding the fiscal cliff at that time. Analysts have been raising full year estimates for 2013 but they are underestimating several political factors that may play an important role in the years final outcome. With the fiscal cliff still to be discussed and a debt ceiling limit that currently blocks the access to funds for the US Treasury, it seems that everyone is somewhat complacent overly optimistic.

If the unfinished fiscal cliff business and the debt ceiling debates coming up prove to be as farcical as in August 2011, we may shortly be about to break the trend of historically extremely low volatility. Any serious downside momentum on renewed nerves will see these hedge funds de-leverage their portfolios very quickly and so further contribute to the decline. Guess who’ll be left holding the baby? As ever, the retail investor!

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