market folly

You might be surprised by the fact that hedge fund returns in the second quarter of 2010 might be the worst since late 2008, according to Bank of America Merrill Lynch. Obviously this is largely due to the ramp up in volatility and subsequent decline in equity markets that took place in May and June. May was a brutal month for hedgies and now as June performance numbers trickle in, we're seeing big players suffer. For instance, John Paulson's Recovery Fund was down 12% and his Advantage Plus Fund lost 6.9%. And despite Lee Ainslie of Maverick Capital's notion that 2010 would be a stockpicker's market, many long/short funds have been hammered.

Last week we examined the latest exposure levels of many funds and saw that they had historically low net long exposure in equities. Despite this, they continue to pump out poor performance numbers. Let's take a look at things to see if we can get a better idea as to where they've gone wrong.

Given the recent market decline, it's almost as if hedge funds have been reactive rather than proactive. Many of them clearly expected a pullback as they had been reducing net long equity exposure since the beginning of the year. Yet while they reduced risk/exposure levels, they weren't proactively building their short book as much as they maybe should have... until now, seemingly after the majority of the recent decline. Bank of America notes that the "aggregate adjusted short interest (ASI) for the S&P 1500 increased 6% from its lowest levels in more than three years. This is the largest one-time increase since early March 2009."

This notion implies that there is much more room for hedgies to increase short positions. At the same token, large increases in short interest has also served as a contrarian buying opportunity on many occasions. On a sector basis, the largest increase in short interest has recently been in Financials, Utilities, and Health Care.

Bank of America also updates us on the performance of their hedge fund generals index. This strategy that compiles a basket of the most favorite stocks among hedge funds is down 6% year to date versus the S&P which is down 7.6%. In 2009, the hedge fund generals index outperformed the S&P by a whopping 46%. Those of you with Bloomberg terminal access can pull this up using MLDIHGFN. We've also covered the stocks listed on the hedge fund generals index here.

So while the hedge fund consensus picks have lost money this year, they are still outperforming the general market indices. Some funds are even bucking the trend entirely, such as Dan Loeb's Third Point who is up over 10% year to date. Those of you looking for what the consensus hedge fund picks are these days would also be interested in Goldman Sachs VIP list.

Lastly, let's focus on where hedge funds have been positioned as of late. As the second quarter came to a close, hedgies were largely net long gold, short the S&P 500 and Russell 2000. Additionally, many have been long the US dollar and short the euro. The most recent data suggests that hedge funds are 27% net long equities, down from last time's 30% exposure and well below the historical average of 35-40%.

In treasuries, hedgies continue to add to crowded short positions in the 10 year and 30 year. Additionally, they partially sold their net longs in the 2 year. Many funds held their positions in various precious metals steady and some sold crude oil. Embedded below is the latest hedge fund monitor report from Bank of America Merrill Lynch:



You can download a .pdf copy here.

So despite reducing exposure levels, hedge funds still seem to have taken it on the chin in May and June. Many funds have re-actively boosted short exposure in hopes to stem further loses. What's interesting is such a maneuver in the past has marked a contrarian buying opportunity (at least in equities). And, that's exactly what seems to have happened recently as markets have rapidly bounced. This almost makes you wonder if hedgies will put in poor performance numbers again if this keeps up. We'll have to see how they position themselves ahead for the rest of the year and if they engage in further knee-jerk reactions. Head here for more recent broad hedge fund exposure levels and here for Dan Loeb's hedge fund specific exposure which was updated this morning.