Hedge Fund Meltdown Accelerates, And There Is No End In Sight

It’s already been an abysmal month for hedge funds, as the Goldman Hedge Fund VIP Index clearly demonstrates…

… having just suffered its worst month on record…

… and with every passing day, it’s only getting worse as hedge funds, forced to deleverage in this chaotic market, are unable to pick a correct side of the market and stay on it.

Consider that according to Nomura’s Charlie McElligott, Monday was fifth worst one-day drawdown for his U.S. Equities Long-Short Hedge Fund model year-to-date, as the now daily shakeout continued in the form of accelerated deleveraging of legacy status quo positioning, i.e., popular shorts/underweights in “Value” and “Quality” ripping higher, while consensual longs overweights in “Growth” and “Momentum” were once again violently reduced.

Commenting on the “extreme and much-discussed” – not to mention 10 years overdue – outperformance of U.S. Equities “Value” over “Growth” yesterday, McEllgiott notes that optically it looked just as much about forced “grossing-down” (selling longs, covering shorts as higher realized volatility dictates VaR-based exposure reduction) as it did about ongoing “end-of-cycle” factor rotation catalysts or macro inputs (i.e. steeper curves benefiting “Value”)

Of note, and what to McElligott was “pretty interesting” was this: even when SPX was +1.4% and at the highs….broad “Value” factor metrics were meaningfully outperforming their “Growth” counterparts (while “1Y Momentum” was outright lower all session); or as he explains “it has been a VERY RARE occurrence to see “Value” to outperform the multi-year leadership regime of “Growth” and “Momentum” in a “gap higher” Equities tape.”

What does this mean according to the Nomura strategist:

“Value” over both “Growth” and “1Y Momentum” has obviously been a feature of the month-to-date landscape, especially as investors were very clearly been re-pricing LOWER their expectations for U.S. economic growth, in conjunction with the “pulling forward” their “end of cycle” timing into 2019

More ominously, and in keeping with what Goldman noted when looking at the VIX curve, this “Value” outperformance over “Growth” is in-line with historical factor leadership data across late-cycle transitions, as investor mentality seemingly pivots from “pre-recession” towards outright “end-of-cycle” / “recession” style rebalancing.

in a recession, outside of “Low Volatility” and “Dividend,” it is “Value” which is the next-best performing factor; conversely, investors do not want to be stuck long “expensive” stocks into the eventual slowdown.

All of the above is bad news for hedge funds: as shown in the chart below, equity hedge fund performance continues to suffer due to legacy positioning effectively being “long high beta” vs “short low beta”, which means that despite cutting net exposure to lows, they still bleed on high “market” exposure:

That said, McElligott believes that “THIS current freak-out is not “the one”—instead, it will be the early-to-mid 2019 event where after the 2nd hike the market “sniffs the slowdown,” the curve powerfully steepens, and we see the “ultimate” risk-off trade (and the “sustainable” Value over Growth” move).” Instead, the current market in my eyes remains a “de-leveraging cleanse” off the back of a Fed “policy error” scare.

Unfortunately, for battered hedge funds – who just saw a spike in redemption requests in September – it doesn’t matter: once their LPs see the latest disastrous performance, the outflows will accelerate forcing even more derisking, deleveraging and debuying.

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