More Signs of Better Days Ahead for Hedge Funds?

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So far, 2016 has unfolded in a way that many active investment managers were hoping for. Market volatility has been increasing, affording more opportunities to buy and sell securities at attractive levels. Share prices have stopped moving higher in a relatively straight line, no longer favoring those who prefer to buy and hold. And bottom-up fundamentals seem to matter much more than they did in the risk-on/risk-off world of the past several years.

Unfortunately, things haven’t quite worked out as planned. Certainly, some categories that looked set to outperform, most notably systematic investment managers—discussed here—are living up to expectations. Based on data compiled by HSBC, the average managed futures—or Commodity Trading Advisor (CTA)—fund was up 6.19% as of February 19, according to Business Insider, in contrast to the single-digit losses hedge funds as a group have registered since the year began.

Pack-like behavior

One reason why some managers, especially those that can go long or short, have fared poorly despite a more stock-picker-friendly environment appears to stem from the overcrowding and overconcentration trends that came to the fore in an environment where risk-taking was actively encouraged. Some also maintain that the imbalances reflect an industry that has too much capacity and not enough talent.

Regardless, while the Federal Reserve’s December decision to initiate a tightening cycle changed the game, a number of the positions that were initiated before the shift are only just being unwound. This can be seen in data on the performance of stocks that are either widely held (or shorted) by hedge funds, or where managers, individually or collectively, have focused their attentions.

Research by Goldman Sachs, detailed by MarketWatch, finds that in 2016, “stocks with a high level of hedge fund ownership have underperformed the S&P 500 for the first time after four straight years of beating the market.” According to the investment bank, the 20 companies with the largest share of market capitalization held by such managers have lagged the equity market benchmark by 457 basis points since the year started.

Getting hit from both sides

Other data tells a similar tale. According to ValueWalk, research published last week by Credit Suisse reveals that the top 50 longs and shorts held by equity long/short hedge funds have underperformed in February, the first time that has happened since January 2013. Among other things, the report points to “high position concentrations and industry rotations that caused popular shorts to rip higher while punishing longs lower.”

Additional evidence that bearish hedge fund bets, in particular, are being reluctantly or involuntarily unwound can be found in a recent commentary from Goldman Sachs Asset Management. According to portfolio manager Osman Ali, “the stocks with the largest bets against them have been on a tear lately,” reports Business Insider.

For the three months leading up to February 19, the return on the most shorted stocks in the U.S. “reached heights not seen since the third quarter of 2011—when Standard & Poor’s cut the U.S.’s triple-A credit rating—and even exceeded the peak during the financial crisis in 2008,” Ali wrote in a recent note.

A silver lining?

If history is any guide, the impact of such developments will likely prove short-lived, suggesting that it is only a matter of time before things return to some level of pre-easy money normalcy and performance improves. Those with large pools of capital to invest appear to have reached a similar conclusion. Chief Investment Officer reports that “even after a year of middling returns, nearly half” of asset owners surveyed by Deutsche Bank “plan to grow their allocations” to hedge funds. According to the bank, 41% are seeking to increase exposure this year, while only 11% plan on scaling it back.

Its is possible that a changing investing environment will not prove to be the panacea for active management performance that many had hoped. As alluded to earlier, some observers believe that one reason for the hedge fund industry’s disappointing performance in recent years is a relative abundance of mediocre managers. Whether true or not, it seems that the troubles that have caused a number of firms to retrench or go out of business may well have a silver lining.

That is because “the spate of hedge fund closures that rocked Wall Street last year might actually be a bounty for others in the industry,” writes Fortune; it has given some of the U.S.’s top performing large hedge funds the opportunity to open “their doors to fresh hires.” According to the head of executive search firm Whitney Partners, “there are some funds that are seizing the moment to take advantage of quality people who were in the wrong place at the wrong time.”

The strong remain standing

Moreover, as with any industry, odds are that the shakeout that has forced a growing number of firms to close their doors will leave standing those that have the acumen and the staying power to produce results that allocators are searching for.

One sign that things are looking up is the fact that a few savvy operators are betting on a brighter future. A New York Times article notes that

some of the managers who have waited patiently for years as the stock market hit one new high after another, now sense opportunity in the market turbulence and a chance to make big, bold bets on the volatility in stocks, bonds and commodities.

According to Adam Sender, a well-known collector of contemporary art who shuttered his hedge fund two years ago but who has recently decided to launch another, “‘It appears a major sea change in the way the markets work may be at hand.'”

In other words, perhaps now more than ever, as previously discussed, there are signs of better days ahead for hedge fund investing.