When commenting yesterday on the ongoing bloodbath in the hedge fund space, which has been far worse than the drop in the overall market, we highlighted a perverse trap that the “smart money” appears to be caught in: as a result of the recent spike in realized vol, coupled with rising redemption requests, “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.”
With that in mind, traders will be curious if yesterday’s furious dead cat bounce melt up in stocks provided some relief to hedge funds?
As it turns out, the answer is no with the “trapped” thesis dominating, because as Nomura’s Charlie McElligott writes, despite the powerful U.S. Equities index-level rally, “the particulars of the sector- and factor- leadership meant another very large underperformance day for the buyside again, with “consensual underweights / shorts” (Materials, Oil & Gas, Energy Equip & Services, Food Beverage & Tobacco, REITs, Staples, Household & Personal, Telcos, Consumer Services, Insurance, Banks) up as much or more than “popular overweights / longs” (Software & Services, Media, Retailing, Tech Hardware, Consumer Durables).”
It gets worse: as the Nomura strategist calculates, yesterday was the 3rd largest one-day underperformance for the Equities HF L/S benchmark vs SPX since Feb 2016, and the 10th worst underperformance day vs SPX since Oct 2014
Why is this important? Because while it is generally accepted that October’s drop has been largely a function of “slow money”, active hedge fund management deleveraging, selling and liquidations, nobody has countered where the reflex knee-jerk response buying would come from (aside from buybacks of course).
We now know it won’t be from hedge funds, who are forced to delever even as the market rallies.
As McElligott further explains, “without question and worth repeating, this underperformance / “shock drawdown” within the U.S. Equities fund space weakens the basis for “performance-chasing” mentality into year-end as sentiment pivots to “defense” from “offense,” with little-to-no “ammo” across the generic fundamental / discretionary Equities space.”
That said, one possible source of buying pressure would be the tactical Macro funds, who have gotten the rates-trade “right” and have the dry-powder to put on the upside view, with some according to Nomura have already begun this pivot playing “wingy” bullish trades in index / ETF. At the same time, and with a far smaller scale now due to their own performance issues YTD, Systematic “Mechanical Rebalancers” will “by rule” need to re-leverage on a move higher as “rich vol” will be reset lower. This goes to Kolanovic’s thesis for why a bounce is overdue.
Finally, as McElligott shows in the following chart, at the end of the day, the catalyst for any day-to-day move will be global financial conditions, which have been shrinking rapidly in the past month and will continue to shrink as we enter November when global central bank liquidity flows turn increasingly more negative for the first time since the financial crisis.
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