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The Hedge Fund industry has navigated the most challenging market environment in decades pretty well, with -2% gross of fees returns through the end of November. Hedge funds have been able to preserve capital by playing defense effectively in 2022 as we noted previously in the blog here and here. As we look at their positioning heading into 2023, there are signs that funds are picking up their search for opportunities. Risk taking is starting to pick up and funds are increasingly looking toward small/midcap, value stocks, and various places in the credit stack for opportunities. This all suggests that Hedge Funds are seeing more opportunity to generate return entering ‘23 after a year laser focused on capital preservation.
2022 has been a difficult time across most asset classes with commodities as the only assets providing a positive return on the year. Hedge funds have performed in line with defensive stocks, value, gold, and dollar cash - all of which typically do well during different market environments.
While the industry as a whole did pretty well this year, 2022 saw some of the biggest divergences in Hedge Fund style performance in many years. Strategies like Managed Futures and Global Macro outperformed significantly and saw their best returns in years. Strategies that have a bit more beta like Long Short Equity and Emerging Markets were weaker, but still significantly outperformed benchmark passive indexes highlighting the alpha these strategies produced even in a down environment.
An important reason funds overall were able to preserve capital in 2022 was by cutting the amount of risk taking in assets relative to normal. During most of ‘22, funds were running leverage around the lows of the last 20 years (excluding crisis periods). That helped funds which typically have some asset beta deliver outperformance as the market weakened. In the last couple months, we have started to see a bottoming of that low leverage and some signs that funds are picking up their positions.
The pickup in positioning in the last couple months has come in both the stock and the bond markets. At this point, funds are getting closer to more normal positions in these markets, though they remain underweight duration.
Probably the most interesting dynamics are under the hood in the equity market. Funds continue to run very underweight growth oriented sectors relative to history. We are seeing net short positioning in tech, as an example. In contrast, they have been picking up their exposure in a couple other areas. Funds are substantially overweight stocks of smaller companies relative to history and hold close to normal positions in EM and value. These positions represent a continuation of conservative positioning seen in 2022, but are starting to show signs that there are opportunities available in the market.
The shift to increase positions in the smaller side of the US equity market is likely reflective of the significant valuation differences between Large Cap US stocks and small and mid-cap stocks. Even with the declines this year, large and mega cap stocks PE ratios are priced at elevated levels whereas small and midcap stocks are priced near crisis lows (of course yields are higher today).
As we enter 2023, there are signs that Hedge Funds are starting to look for incremental opportunities to add risk to their portfolios. This suggests that while there may be continued overall pressure on financial markets, it may be time to stop fully playing on the defensive, and that there are opportunities to outperform by focusing on various sectors which do better given the confluence of conditions and pricing today.