Hedge Funds Are Highly Invested in Stocks. Here’s Why That Could Be a Problem.

By Jacob Sonenshine

           Hedge funds surveyed by Evercore strategists have a 51% net equity exposure.

Hedge funds have been buying up stocks of late, but if history is a guide, the trend could reverse itself—and that would be a pressure point on stocks.

Hedge funds’ net equity exposure has risen sharply in the second half of 2020 as the stock market has spiked from its pandemic-induced bear market in March. 

Net equity exposure is the total percentage of a fund represented by long positions in stocks, minus the percentage of the fund in short positions on stocks it is betting against.

Hedge funds surveyed by Evercore strategists have a 51% net equity exposure, meaning the majority of hedge-fund positions are long, a sign those investors are optimistic on the market. 

That exposure is up from just above 48% at the end of the first half of the year.

This level of exposure is relatively high historically. The long-term median for Evercore’s survey, displayed in a graph, shows hedge funds at roughly 48% net exposure. 

The current level is in the 75th percentile of exposure.

The caution is that these investors might start reducing risk sooner rather than later. 

“December’s backdrop is quickly becoming one that encourages reducing hedge fund net exposure,” Dennis DeBusschere, Evercore’s head of portfolio strategy research, said in a note. One “binary event” he warned of is the runoff election in Georgia for the U.S. Senate. Control of the Senate hinges on the two races.

If Republicans keep control, then Congress would be split, a scenario that would make big fiscal spending less likely than if Democrats controlled the House and the Senate. 

That could be a negative for the economy and economically sensitive stocks, although with fiscal stimulus expected soon and Covid-19 vaccines being delivered and administered, a split Congress might be not so bad for stocks.

To be sure, a split Congress would benefit traditional oil and banking companies, because it would mean less stringent regulation on those industries.

Still, investors loathe uncertainty, and with the Georgia runoffs not being decided until Jan 5, highly exposed investors might want to avoid some volatility.

In any event, if hedge funds take some chips off the table, that would create selling pressure in the stock market. 

Other investors are part of the mix, as well. 

Individual investors have contributed substantially to market gains during the year, but when wealthy hedge funds unload long positions, that pressure can often overwhelm positive forces for stock prices.

The market has largely priced in another fiscal stimulus bill this year and the approval of Covid vaccines. 

The Vanguard S&P 500 Value Index Exchange Traded Fund —value stocks are highly correlated to changes in the economic outlook—is up just under 9% since Nov. 6. 

That was the last trading day before biotech giants announced their vaccines were almost 100% effective and preceded several positive fiscal-stimulus developments. Now, negative surprises on those fronts leave stocks vulnerable. And since Dec. 4, stocks have taken a pause and the value fund is down 1%.

In the short-term, stocks might have more downside than upside.

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