Hedge funds up leverage, but fear directional bets with blurred macro picture

Hedge funds are increasingly using more leverage to make wagers on the stock market this year, but they remain less inclined to bet on the market direction due to heightened macroeconomic uncertainties.

Investors are focused on the economic picture as they try and assess the risk of upcoming recession as the U.S. Federal Reserve tries to bring inflation under control by hiking rates aggressively. On Wednesday, Federal Reserve’s chair Jerome Powell said future interest rates hikes could go higher than market participants anticipated to fight inflation.

Hedge funds’ gross exposure, or the sum of long and short positions - bets shares will rise and fall - as a percentage of their assets under management, last week reached peak levels for the last one year according to Goldman Sachs’ prime services weekly report.

Gross exposure went up 2.5 percentage points for the period between Feb. 24 and Mar. 2, to 241% of assets, the report showed.

However, their long wagers minus short ones, known as net exposure - a measure of directional risk appetite - is close to a year low of 66%, Goldman Sachs showed. This illustrates that portfolio managers have little bias on overall market direction.

Hedge funds’ more market neutral approach comes as market participants are trying to guess how high interest rates will get, for how long and when inflation will show consistent signs of decline - and its impact on the stock market.

Goldman Sachs, one of the biggest prime brokers, uses its clients’ database to capture trends. Although the report does not reflect the entire $4 trillion industry, other market participants have expressed a more cautious approach.

Volatility has caught hedge funds off-guard. In the beginning of the year, an unexpected rally forced hedge funds betting against stocks to abandon those trades at the fastest pace since 2015. The S&P 500 went up roughly 9% at its peak in February 2, but trimmed gains to 4% now.

“Investors are not in full risk-on mode,” said Eamon McCooey, head of prime services at Wells Fargo, adding his clients’ dry powder are close to peak levels.

Long-short hedge fund Anson Funds, with $1.5 billion in assets under management, is roughly neutral, with shorts and longs matching off, portfolio manager Moez Kassam said. He said the fund is keeping cash and unused limits higher than in previous years due to economic uncertainties.

“Our macro view centers on inflation,” he said. “It will stay elevated longer than most expect.”

Higher interest rates are also forcing investors to make until recently unthinkable calculations, said Rob Christian, co-head of research and investment management at hedge fund solutions group K2 Advisors, which manages a fund of hedge funds, as cash may provide a good return.

“Our hedge funds in general have been taking less risk,” he said. “Now two-year Treasury is a very attractive asset class relative to everything.”

The surge in activity has been welcomed by bankers and lawyers working on these offerings. Collectively they executed $72.5 billion worth of stock sales for public companies in 2022, the lowest level since 1996 and a 67% drop from 2021’s deal bonanza, according to Dealogic data.

“Investors are willing to put money to work in a way that they weren’t a year ago,” said Michael Kaplan, a capital markets partner at law firm Davis Polk.

The next frontier for equity capital markets, bankers and lawyers say, are initial public offerings (IPOs), which have been subdued since Russia’s invasion of Ukraine in February 2022. Unlike secondary stock sales, IPOs take at least a few days to market to investors, and several months to prepare, so companies can’t be as nimble in pursuing them when the market becomes welcoming.

A busy week for initial public offerings in early February offered some hope to stock market hopefuls, but advisors remain cautious as stocks sold off in recent weeks.

Fourth-quarter earnings season is on the final stretch, with all but seven of the companies in the S&P 500 having reported. Results for the quarter have beaten consensus estimates 68% of the time, according to Refinitiv.

Still, on aggregate, analysts believe S&P 500 earnings will have fallen 3.2% in the fourth quarter compared to the prior year, and expect negative year-on-year numbers for the first two quarters of 2023. This would imply the S&P 500 entered a three-quarter earnings recession in the closing months of 2022, per Refinitiv.