(Bloomberg) -- How’s this for an election trade? Sell your winners now so you have cash on hand this fall to do some aggressive buying as the political jockeying heats up.
That’s precisely what hedge funds have been doing since May, even as the market continued to set records. Their net leverage, which is often viewed as a barometer of risk appetite, fell to 54% in early July, the lowest level since January, according to Goldman Sachs Group Inc.’s prime brokerage desk. Hedge funds are now underweight technology, media and telecom by the most on record after spending two months unloading the best performing stocks in the market.
This, however, is not a bearish trade. Rather, the so-called smart money is gearing up for a wild presidential campaign, and the funds want cash ready to be deployed immediately as stock market volatility rises and share prices start to swing.
“Managers need to have some powder dry for potential dislocations around the US election,” said Jonathan Caplis, chief executive officer of hedge fund research firm PivotalPath. “The net selling is just a strategic profit taking. It’s tapping the brakes rather than a stampede for the exit.”
It’s easy to see why traders are prepping for a volatile election season. Democrats are still figuring out who to run as calls mount for President Joe Biden to step aside over concerns about his age and physical frailty. Meanwhile, Republican nominee former President Donald Trump is proposing an economic agenda that features tax cuts, tariff hikes and curbs on immigration, which is spurring concerns of surging inflation and weakening US finances.
Known events with unknown results create a trading environment where dispersion, or the range of potential outcomes when equities move in different directions, rises on individual stocks. That’s what hedge funds like to see, since they typically take both long and short positions in their bets.
Early Start
With all the uncertainty, some traders expect the campaign to spill over into stock market earlier than usual.
“What we’ve been hearing from hedge funds this year is that the election story might happen much sooner than November,” said Adam Singleton, chief investment officer of External Alpha at Man Group Plc. “It’s prudent and it’s good portfolio management to reduce risk going into uncertain binary events.”
Hedge funds’ exposure to stocks typically declines leading up to a presidential election. Then, managers quickly re-leverage shortly before the vote, and keep adding to their positions afterward. Current net exposure is still above the long-term average for an election cycle, according to Goldman Sachs data, indicating there’s still room for selling.
“Usually around these big events it can be a lot of shooting first and then analyzing later,” Caplis said.
There are a few ways hedge funds typically trade political events. One is from a sector perspective, where managers identify themes that will benefit from each candidate, reduce exposure before the vote and then bulk up on the winning theme afterward.
Another is to gauge the market’s overall risk appetite, which can be seen as a proxy for the direction of equity prices. In that case, funds reduce net exposure and then try to get a sense of how investors view the winning candidate. This wait-and-see approach worked well in 2016, when markets were expected to fall if Trump won but instead rallied on his victory.
Hardest Bets
Then there’s the riskiest approach, which is to focus on specific companies or small groups of stocks in the expectation that they will do well or poorly based on who wins. Those are the most difficult bets to make as market pricing can move wildly once a winner is declared.
“A lot of managers will try to see how the landscape is developing after the election and move in then,” Singleton said.
Right now, there’s a serious risk for funds that want to aggressively unload positions in the big tech stocks that have been driving the market higher for the past year, like Nvidia Corp., Meta Platforms Inc., Amazon.com Inc. and Google-parent Alphabet Inc.
While the rotation may make sense, and ultimately these stock prices should level off, if they continue to defy gravity and push higher in the short term a “flat squeeze” can emerge, said Frank Monkam, senior portfolio manager at Antimo. In that case, more investors buy in as the anticipated downturn fails to materialize, creating a self-fulfilling cycle of climbing share prices.
Ultimately, November’s trading will determine if unwinding winners was the correct call. Hedge funds can use the returns, as they’ve been trailing the S&P 500 Index for the past four years. US long-short fundamental hedge funds added 7.4% in the first half of the year, according to PivotalPath, compared with a 14% gain in the S&P 500.
One area where hedge funds are already winning is in demand for their services. As the election approaches with stock prices near record levels, investors are growing cautious and increasingly seeking guidance on how to position themselves.
“Investors are worried about valuations of the equity market, and they want to be hedged,” said Don Steinbrugge, chairman of global hedge fund consulting and marketing firm Agecroft Partners, who is seeing the largest demand for long-short equity fund managers since 2013. “If they weren’t concerned, they would just be buying an index fund and pay almost no fees.”
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