Equity Market Exposure Rises With The Rally

The quarterly hedge fund “hold ’em and fold ’em” report

SHAN HASNAT AND MARY ANN BARTELS, BANK OF AMERICA MERRILL LYNCH

Market exposure continued to rise in the third quarter of 2009 with the net rising to 130%. As the equity markets surged in the spring, hedge funds ramped up exposure to US stocksin the second quarter. That trend continued into the third quarter with hedge funds significantly increasing their directional bet.

Based on quarterly 13F filings and estimated short positions, we calculate gross equity exposure (to the Russell 3000) rose 14% quarter-on-quarter in the third quarter of 2009 to $825 billion, while net exposure jumped 130% to $95 billion. Hedge fund ownership of the US equity market float continued to improve to 4% from 2.6% at the end of 2008, with much of the additional buying occurring in the large caps rather than in the mid and small caps. Furthermore, we estimate hedge funds continued to raise leverage in the third quarter, which is back near second quarter 2008 levels at 1.2x.

Hedge funds continued to increase their technology holdings in the third quarter and poured into consumer discretionary. They also moved into a net long position in financials for the first time since the fourth quarter of 2007. But hedge funds also moved further into defensive sectors such as health care and consumer staples and continued to sell industrials, which is now their least favourite sector. (Note: quarterly filings are as of 30 September 2009 and holdings may have changed significantly since then.)

merrill1

merrill2
merrill3a
merrill4

HF Generals outperform
The Hedge Fund Generals is a cloning strategy combining the most concentrated and the most popular stocks among hedge funds each quarter. This strategy is up 62% for the year-to-date and has outperformed the S&P 500 by a substantial 41% YTD and by 69% since the lows of November 2008.

To construct the HF Generals basket we took those stocks in each quarter that ranked in the top quartile of both the most widely held stocks (popular) and those with the heaviest hedge fund ownership (concentration), sorted by concentration. The basket is rebalanced quarterly and our universe of stocks is the S&P 1500. There is of course a delay of up to 45 days between quarter end and the deadline for filing 13Fs. In backtests, to avoid look-ahead bias, we took an even more conservative 60-day lag. The strategy has outperformed the S&P 500 index by 90 basis points per month (and 270bp per quarter) between the third quarter of 2003 and the second quarter of 2009. The basket has a beta of 1.26, based on which we estimate alpha of 81bp per month.

Analyzing net sector exposure
In this section, we combine analysis of hedge fund long positions from quarterly 13F filings with our estimate of HF short positions, based on short interest data released by the NYSE and NASDAQ exchanges, at the sector level. Hedge funds are the primary reason for the sharp increase in short interest levels in recent years and we estimate that they are now responsible for 85% of total shorts in the market. For the analyses that follow, we maintain the same proportion of shorting across sectors and our universe of stocks was the Russell 3000. Hedge funds continue to buy technology, and financials, while selling industrials.

Analyzing both long and short positions on a dollar basis, we find hedge funds continued to pile into technology in the third quarter and moved aggressively back into consumer discretionary. They also continued to buy financials and are now net long the sector. However, hedge funds did “hedge” by also moving further into defensive sectors such as health care and consumer staples in the third quarter and continuing to move out of industrials.

Net long financials
Hedge funds by and large successfully shorted the financials sector in early 2008 and avoided the worst of the equity meltdown in the September-October period. Beginning in the fourth quarter of 2008 they began to cover their deep net short position inthe sector. Covering accelerated in the last two quarters, with hedge funds moving into a net long position in financial in the third quarter for the first time since December 2007. They are very bullish on the large diversified financials – the largest sub-sector – and are also constructive on insurance and capital markets. However, while hedge funds may have changed their opinion on the biggest financial companies, they are still very cautious on commercial banks and REITs.

A closer look
As we noted earlier, hedge funds are most invested in technology, health care, consumer discretionary and consumer staples. Within these sectors, there are a few prominent industries in which hedge funds have large long and short positions that drive the asset flows. Below we highlight some of the key industry groups.

Technology: hedge funds heavily favour IT services, computer & peripherals and communications equipment, while remaining bearish on semiconductors. Key stock positions (on a US$ basis) include Visa, Master Card, Apple Computer and EMC.

Health Care: hedge funds assets are concentrated in health care providers and pharmaceuticals. Key stock positions include Wellpoint, Pfizer, Merck WLP, Express Scripts SRX and Valeant Pharmaceuticals.

Consumer Discretionary: hedge funds most favour media and multi-line retail in this space while disliking household durables and hotels & restaurants. Key stock positions include Cable Vision, Time Warner, Sears and Target.

Consumer Staples: hedge funds love food and staples and then beverages but not tobacco. Key stock positions include Caremark, Walgreen, Pepsico and Pepsi Bottling.

HF Generals
We have often highlighted different investment strategies based on hedge fund holdings and tracked their performance over time. Our choice strategy is the HF Generals – an equal-weighted basket of 20 stocks that is a combination of the most concentrated and most popular stocks among hedge funds (i.e. stocks that a larger number of hedge funds have high conviction in). This strategy has outperformed the S&P 500 index by 90bp per month/270bp per quarter between the third quarter of 2003 and the second quarter of 2009 (which is statistically significant at the 90% confidence level).

More recently, the strategy has outperformed the broader market by a substantial 41% in 2009, gaining 62% YTD. However, the HF Generals index did suffer steep losses between September and November last year – dropping by 56%, as hedge funds were forced to liquidate in response to record redemptions; it has rallied nearly 106% since. The index has a heavy tilt toward consumer Discretionary and IT with a mid/small cap bias.

Methodology
Hedge fund holdings analysis based on quarterly 13F filings which requires filings from institutional investment managers who exercise investment discretion over $100 million or more in Section 13(f) securities. Quarterly 13F filings were obtained from LionShares via FactSet. The findings in this report were based on data from 820 hedge funds with over $650 billion in total equity assets (including, options, warrants, convertible debt, etc). The analyses in this report, however, were limited to stocks only and the universe of equities was in most cases the constituents of the Russell 3000.

We obtain short interest data for stocks from the NYSE and NASDAQ exchanges via Bloomberg. Short interest is reported semi-monthly (mid-month and monthend). For our analyses, we aggregate individual stock short positions up to the sector and market cap levels. The dramatic rise in shorts in recent years is strongly correlated to the rise in hedge fund AUM.