Hedge funds improved their performance during the pandemic, but that changed in March. According to Morgan Stanley, it looks like hedge funds could underperform for a while because they aren't rotating into the new momentum names.
Hedge Funds Rotate Into Media
Morgan Stanley strategist Katy Haber and her team said hedge fund flows at a high level have been mixed. However, the technology, media and telecom sector continues to be the one area in which they have seen more rotations under the surface. The two most interesting trends have been the rotation into media and the lack of buying in large-cap tech names.
The Morgan Stanley team said media had been one of the best-performing industries year to date, as the S&P 500 Media Index is up 18.9%, compared to the S&P 500's 4.5% gain. The media industry has also been the most net bought by hedge funds across sectors with the most long additions across industries and the second most short covers after specialty retail. These moves have pushed net exposure to the highest level they have seen since 2016.
However, net exposure to large-cap tech is close to 12-month lows. Flows across those names have been paired off since early January, while net activity to other stocks has skewed toward buying. Flows started to reverse at the end of March, although the magnitude of buying in large-cap tech remained limited.
Hedge Funds Avoid New Momentum Names
One question the Morgan Stanley team has been asked frequently is whether hedge funds have begun rotating into stocks that will likely become the next momentum names in the coming weeks. They believe sentiment toward these areas, such as Energy, Materials and Financials, remains low, as hedge funds haven't been adding to long positions in them.
Haber and her team added that both long/ short equity funds and quant funds have avoided this rotation. They also said net exposure to momentum remains high, although long/ short equity funds are the ones that are more exposed. Quant positioning to momentum is more moderate compared to history.
Mixed News On Cyclicals In North America
The Morgan Stanley team found that flows to North American cyclicals have been mixed lately after driving much of the positive activity in the first six weeks of the year. Month to date, cyclical flows in North America have only been marginally positive, with long additions outpacing short adds. The ratio between net exposure to cyclicals to defensives has ticked slightly higher following the positive flows. However, the relative underperformance of cyclicals month to date is offsetting part of the rise.
One area within cyclicals where hedge funds have been bullish is leisure names that are strongly correlated to the reopening trade. Based on flows to the Leisure index, hedge funds have been buying these stocks since late January, and exposure has climbed close to highs recently.
Meanwhile, hedge funds have been hesitant to add to reflationary names and have been net sellers of those stocks most of the year so far. The selling came from both long selling and additions of short positions even though the reflationary trade has been outperforming year to date. The Morgan Stanley team added that net exposure to the constituents of the Reflationary Index previously hit a high near the end of 2020. However, levels have since fallen to the 78th percentile over the last 12 months.
European Cyclical Rotation Is Underway
The cyclical rotation in Europe is a different story. Hedge funds there have been rotating away from defensives and into cyclicals since the beginning of the year, unlike the slowdown observed in North America. The net buying in European cyclicals has been led by autos, capital markets, specialty retail, internet retail, and hotels, restaurants, and leisure.
In defensives, the net selling among hedge funds has been led by aerospace and defense, food products, diversified telecom and personal products. The Morgan Stanley team added that the activity is in line with the outperformance of net exposure to cyclicals versus defensives pair, which is up 9.3% year to date. The ratio of net exposure to cyclicals versus defensives rose to its highest level in three years.
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