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Hedge Funds Are Back To The Value Rotation But With Pricey Growth Stocks

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Hedge funds started the year off with a bang, but they've been struggling in the last six months. According to Goldman Sachs GS ' Hedge Fund Trend Monitor, U.S. equity hedge funds are up 13% year to date but only 3% for the last six months. Additionally, the most popular hedge fund long positions have lagged the S&P 500 by 16 percentage points since February, which may explain why hedge funds are struggling.

Slightest growth tilt since early 2015

Goldman reports that funds entered the fourth quarter with their smallest tilt toward growth since early 2015. However, that's working against them because growth has outperformed so far this quarter. Interestingly, while funds rotated away from growth and toward value, they've maintained their positions in expensive growth stocks despite their growing preference for value stocks.

Hedge funds are usually tilted toward growth stocks, but they started to rotate toward value in the middle of last year when the economy and stock market started to rebound. The firm added that funds temporarily shifted back to growth in the second quarter of this year but resumed their value rotation during the third quarter.

Since the fourth quarter began, Goldman's sector-neutral, long/ short growth factor has returned 4%, while the Russell 1000 Growth Index has outperformed the value index by seven percentage points. If this trend continues and hedge funds continue to shift toward value, the fourth quarter could be just as challenging for them as the third quarter was.

Boosting expensive growth stocks

Despite their rotation out of growth and into value, hedge funds still increased the weight of expensive growth stocks to a new record. Stocks with EV/ sales ratios of over 10 times make up 23% of the Russell 3000's market cap but one-third of U.S. equity hedge fund long portfolios.

That marks an increase from 31% at the beginning of this year and 16% at the beginning of last year. However, hedge funds slightly trimmed their exposures to stocks with EV/ sales multiples exceeding 20 times.

Ultra-low interest rates and a focus on future growth among investors had created a massive premium for companies with rapid revenue growth without any concern for how profitable they are.

The firm added that the average Russell 3000 stock with a consensus revenue growth percentage higher than 20% for 2023 and a profit margin greater than 20% trades at 11 times EV/ sales. That's roughly the same multiple as an unprofitable or nearly unprofitable stock with more than 20% growth.

Goldman also noted that although many of these high growth companies with little to no profits could have bright futures, their current valuations are dependent on long-term future cash flows. That makes them especially vulnerable to the risks of rising interest rates or disappointing revenues.

Additionally, the outperformance of highly profitable growth companies this year, especially during the first quarter amid the increase in real interest rates, highlights how much more attractive they are than growth companies with little or no profits.

Retail trading takes a bite out of hedge fund shorts

Goldman Sachs also identified some interesting trends in shorting during the previous and current quarters. The firm reported that short interest for the typical stock remains close to the lowest level on record, falling from 2.2% of cap at the beginning of last year to 1.5% at the beginning of this year.

Short interest has remained fairly stable since then. Goldman noted that it matches the level of short interest during the 2000 tech bubble, the lowest in at least 25 years. The firm added that popular shorts generally underperformed during the third quarter, but they have rallied since the end of the quarter, dragging hedge fund returns down in the process.

Goldman's basket of the most concentrated short positions trailed the Russell 3000 by more than 20 percentage points between the end of June and the end of October. However, during the first week of November, the shorts rallied 16%, outperforming by 13 percentage points. Goldman found this rally to coincide with an increase in retail trading.

Concentrated shorts in the consumer discretionary and materials sectors had caused the most pain for hedge funds year to date. Those sectors have significantly outperformed the most popular hedge fund positions this year.

Retail traders targeted hedge funds early this year by buying up shares of heavily shorted stocks, and they repeated this move multiple times this year. Although retail traders haven't captured much attention recently, it appears that they are striking back again during the fourth quarter.

Retail trading constrains short interest

One reason short interest has plunged significantly this year is due to high levels of retail trading in the stock market. Retail trading activity surged late last year and early this year but seemed to stabilize over the summer. However, it has come roaring back in the fourth quarter, especially in call options.

Changes in retail trading activity have been seen in the performance of the most popular retail stocks and the stocks with the most concentrated short interest since early last year. Since the beginning of the fourth quarter, retail trading activity has increased. A basket of the most concentrated short positions among hedge funds has rallied 16%, compared to 4% for the Russell 3000.

Favorite retail stocks

The Hedge Fund Trend Monitor listed the top Russell 3000 stocks according to their share of retail trading activity over the last month. Goldman found that the stocks on the list generally have higher short interest than the typical Russell 3000 stock. Of the top 30 stocks favored by retail traders, only AMD and NVIDIA NVDA are also hedge fund favorites.

The top 10 favorite stocks of retail traders are AMC Entertainment, Advanced Micro Devices, Tesla TSLA , Marathon Digital Holdings, Ford Motor Company F , Cleveland-Cliffs CLF , QuantumScape Corporation QS , DraftKings, NVIDIA and Boeing BA . Goldman found a significant divergence between these stocks' third-quarter performance and their performance during the fourth quarter so far.

For example, AMC is up 1,806% year to date and 32% over the last month, but it was flat during the third quarter. AMD gained 69% year to date and 27% in the last month but was only up 8% during the third quarter.

Tesla is up 55% year to date, including a 24% gain in the last month, but it was down 2% during the third quarter. Meanwhile, NVIDIA was up 143% year to date and 23% in the last month but down 3% in the third quarter.

The outperformance of these stocks favored by retail traders further highlights why hedge funds are having such a difficult time in the second half of the year. With hedge funds buying other stocks, they aren't getting the benefit of the backing from retail traders.

Very important hedge fund shorts

Goldman also constructed a portfolio of very important short positions for hedge funds, which is designed as a short hedge for its very important positions for hedge funds. The equal-weighted short basket contains 50 S&P 500 stocks with the highest total dollar value of outstanding short interest.

It excludes companies in Goldman's very important position list and stocks with over 10% of float-adjusted shares held short. The firm added that the constituents of its very important shorts basket are not based on 13F holdings and are not stocks with the highest percentage of short interest.

We should point out that some of the companies on the list of very important short positions are also on the list of retail traders' favorite stocks. For example, the first stock on the list of important shorts for hedge funds is Tesla, which is also one of retail traders' favorite stocks.

Aside from Tesla, the other nine of the top 10 very important short positions for hedge funds are S&P Global, Moderna, Bank of America BAC , Home Depot HD , Intel INTC , Comcast CCZ , International Business Machines, Adobe Systems, and PayPal PYPL .

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