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The current macro environment presents some of the most uncertain circumstances that we have seen in decades. While macro economy data suggests relatively tight conditions and inflation higher than desired across the developed world, increasing strains from the rapid tightening cycle raise questions about whether we are on the verge of a deflationary credit crunch. Add to it the relatively significant uncertainty about the pace of the Chinese reopening and there is significant uncertainty about how these large, offsetting pressures will net out in the coming months.
After entering the year very conservatively positioned and tilted consistent with higher-for-longer macro data, hedge funds have shifted their positioning to be more balanced in recent months. Risk taking has risen from very conservative to more normal levels and positioning is quite balanced across major asset classes at this point. Funds still have some tilts away from US mega-cap stocks and a slight underweight on duration, but those positions are less significant than they were a few months ago.
Put together hedge funds are now pretty balanced to both a continued economic expansion where stocks and credit do well and to a more acute slowing where bonds and gold likely outperform. The following chart shows a summary of current hedge funds positioning:
This assessment contrasts with much of the commentary in the financial press which suggested that hedge funds hold significant shorts in both stocks and bonds. These reports focus on the positioning solely in the futures markets and don't take into account cash market positions funds may have offsetting those futures hedges. By looking at the returns of the managers rather than incomplete positioning information, Unlimited’s return replication technology is able to have a more comprehensive understanding of positioning. That view suggests a much closer to normal exposure to those markets today.
Hedge fund risk taking came into the year about as low as it has been in several decades other than in crisis periods. In the last few months we have seen a modest increase in the amount of positioning that funds are willing to put on reflective of a desire to increase balance across different economic environments that will likely play out, particularly those where the economy is stronger for longer than expected.
While overall equity risk has increased, the composition is still tilted away from the recently best performing sectors like US mega-cap tech stocks. Funds are holding some of the lowest portion of risk in growth stocks as they have in decades, and instead are positioning overweights in stocks with less elevated valuations like in Japan and Europe.
As we talked about earlier in the year, one of the biggest short positions held by funds coming into the year was in US technology stocks. While those positions have been trimmed to about half their previous size, hedge fund managers remain skeptical about the recent outperformance of many of those stocks.
Across credit, hedge fund managers are looking to higher quality parts of the risk spectrum at this point, particularly seeing advantages in the widening credit spread available between agency MBS and the treasury market. When it comes to corporates, managers remain slightly tilted toward the higher part of the capital structure.
Hedge funds in aggregate have navigated this year pretty conservatively, generating only a very small positive return through April and in doing so have trailed broad equity index returns and long-dated bonds which returned 5-10% depending on the exact index and duration mix.
This outcome isn’t surprising given how these funds typically approach navigating challenging environments. This more conservative approach highlights how hedge funds over time achieve improved risk-return outcomes by positioning less aggressively during periods of elevated uncertainty. In any one period, that may result in underperformance relative to index investing to the extent the uncertain environment breaks toward asset price rises, but over time this approach is critical in delivering similar returns of broad stock indexes with much lower risk and drawdowns as a result.
While this first part of the year might not have been particularly exciting for many hedge fund strategies, these funds preserved capital effectively by continuing to execute the game plan that has worked for decades. As uncertainty about how the cycle will break continues to rise, it is likely that these more agile managers are in a much stronger position to navigate this challenging environment ahead.