Equity hedge funds proved their worth in January with an average return of about -0.2%, outperforming equity markets during a temporary downturn that caught many investors by surprise. Investors have been putting more money into defensives since then, according to UBS’ monthly hedge fund update, reflecting the slightly less bullish mood.

“Given the significant sell off in global equity markets, a surprisingly large number of equity hedge funds generated positive returns,” says the UBS report. “Short emerging markets, long developed markets has been a popular hedge fund theme for several months, and this paid dividends in January.”

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Hedge funds – Stock picking strategies may start picking up

While macro effects pushed stock prices up across the board last year, the time finally seems ripe for stock picking strategies. UBS strategist Julian Emmanuel estimates that US stocks that beat on both earnings and revenues are up 2% against the market while stocks that missed on both measures are underperforming by 3.8%. After months of historically levels of PE dispersion, which made stock picking strategies ineffective, the increasing spread in performance is good news for skilled fund managers who can differentiate themselves again.

In response to last month’s dip, and worries that this could be a false lull instead of a rebound to strong growth, UBS customers favored defensive sectors including health care and telecoms to cyclicals in January. The flows were less than a one deviation change, so the UBS report doesn’t think this can be taken as proof that cyclicals are oversold. Consumer discretionary was the least preferred sector among UBS customers, which probably isn’t surprising considering the number of disappointing earnings reports that have come out of that sector.

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Fund flow data shows interest in long/short equity hedges

UBS bought US and global emerging markets (GEM) in January, and the largest fund flows were to equities, according to the report. It’s fairly surprising that in a month when many investors were moving away from US equities in favor of US bonds, and moving away from emerging markets altogether, UBS recorded flows going exactly the opposite direction. ETFs, for example, lost 3.2% of their assets last month as investors moved away from US equities. It seemed that US bonds had been one of the main beneficiaries of the move away from equities, but equity hedge funds may have also benefited as investors wanted to change their type of exposure without turning their backs on equity markets altogether.

UBS found that hedge fund long exposure fell 165% to 164% in January and short exposure increased from 122% to 126%. Since the S&P 500 fell 3.6% of the period this implies that more assets were allocated to both long and short positions in January.

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