Hedge Funds Have Never Been More Levered Or More Invested In The Same Handful Of Stocks

Authored by Christopher Metli, Executive Director of MOrgan Stanley Quant Derivative Strategies
Investors largely shrugged off the factor rotation on Feb 4th as an isolated event, but it shouldn’t be dismissed – higher factor volatility is structural and is here to stay.  Funds are taking bigger factor bets, positioning is crowded, leverage is high, and factor correlations are getting more unstable – all of which mean that future rotations will occur again (probably soon), and will likely be violent.  While fully acknowledging that Fed liquidity is supportive of Growth stocks, it’s also true that the consensus believes the rally in Growth will continue.  As a result QDS thinks the bar is low for an unwind should the economy change in either direction – a growth scare is the worst outcome for most investors, but growth acceleration can be painful too.
In this environment investors should consider:
Replacing longs with upside calls in names that have rallied where volatility is low (i.e. stock replace, keeping upside but limiting downside)
Hedging against sharp moves lower in the most vulnerable areas of the market – Crowded stocks (MSXXCRWD) or Growth vs Value (MSZZGRVL)
First, investors should recognize that the sources of risk have been shifting over the last 10 years.  Factor volatility has been on a steady upward path since 2010.  This impacts everyone (not just quants) because how stocks rank on factor scores now account for an increased portion of the total dispersion in the market.

This increase in factor volatility is not a one-off event, it is a byproduct of HFs making bigger sector and factor bets than they were a few years ago.  As one example, the chart below shows the distribution of Value exposures for discretionary long/short hedge funds in 2010 and in 2019, per public 13F filings.  In 2010 HFs leaned short Value, …
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