Hedge funds have seen their short bets shrink by billions of dollars even as the bearish strategy posts bumper profits – the latest twist in the tale of the stock rout that’s wiped out over $2 trillion in two weeks.
As economic and monetary angst lash U.S. markets into submission, short interest in cash equities as a percentage of market cap has tumbled to near the lowest since 2010, according to Deutsche Bank.
The investing style is often the lifeblood of fast money, and fund managers riding the selloff this way are enjoying banner returns. The least-loved shares, those with the highest levels of short interest, tumbled into a bear market this week in their biggest flop in nearly three years.
Whether it’s because their investing firepower is diminishing or they crave market stability, the bottom line: Smart-money traders have snubbed a key bastion of profitability in the equity meltdown.
“Given the macro uncertainty, there is a bit of hesitation to take high-conviction views on short names,” said Hallie Martin, a strategist at Deutsche Bank. “The fact that the shorts are low as percentage of market cap doesn’t mean there’s not significant opportunity set for investors in a volatile market like this.”
The most-shorted shares in the Russell 3000 – as tracked by a basket compiled by Goldman Sachs – declined more than 12 percent in the 10 days through Monday, the biggest drop since January 2016. The main equity gauge fell by 8 percent.
On Tuesday, those popular shorts tumbled again, even as the broader market ended the session flat.
Managers swimming in a sea of red aren’t grabbing the lifeline. Nearly $100 billion has evaporated from the total value of U.S. shares borrowed to short since peaking in late September, according to IHS Markit Ltd. data, which captures a portion of the total market. That translates to 326 million fewer shares.
Fresh wounds may have something to do with it. Hedge funds were crushed by wrong-way bets earlier this year, when the Goldman basket saw its best quarterly gain in eight years.
“There’s this desire to be gun-shy and not to be betting on some big market collapse,” Sam Pierson, director of securities finance at IHS Markit, said by phone. “If anything, they’ve been taking exposure down so you’re less at risk in sell-offs like this.”
Overall hedge-fund exposure to U.S. equities sits at the lows for the year, according to data compiled by Nomura Holdings Inc.
There’s another, perhaps more ominous, explanation. Rather than a tactical decision to reduce exposure, redemptions and closures in the $3 trillion market may be to blame for the unwind in bearish positions, said Pierson.
As ever, shifts in market structure are also playing a role.
Traders are using options and more liquid exchange-traded funds to express bearish views, often at the expense of single-stock trades. Even so, they’ve delivered across the board – and it would require a big catalyst like a growth scare to up downside wagers right now, said Martin at Deutsche.
“Nobody wants to put on a big single-stock short and have the holiday market rip and hurt their returns,” she said.
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