Mutual and hedge fund favorites have taken a beating in the first quarter so far, dragging down most funds right along with them. Long-only and levered hedge funds were among the hardest-hit as the stock market favored stocks with low institutional ownership. At least one firm has highlighted that individual investors who have bet against institutions have done well, and it’s easy to see why when we look at the extreme underperformance some of the big mutual fund and hedge fund favorites.
Mutual/ hedge fund favorites run counter to the market
The idea that Energy stocks will make a comeback is becoming less and less a contrarian view, particularly in light of the fact that the sector outperformed the S&P 500 last week. Energy climbed 4.6%, outperforming the index’s 2.6% gain; the good news for mutual fund and hedge fund investors here though is that we’re seeing signs that hedge funds are pouring into the sector. Health Care, which has held some key mutual and hedge fund favorites over the last year or so, was the worst-performing sector last week, sinking 1.4%.
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Goldman Sachs analyst David Kostin and team report that Consumer Discretionary, Financials and Health Care made up about half of mutual and hedge fund portfolios and that each of these sectors have so far lagged the S&P 500 year to date. Health Care returned -7.9% year to date, compared to the S&P 500’s gain of 0.4%, while Consumer Discretionary has only gained 0.2%.
Meanwhile, mutual funds and hedge funds have been avoiding defensive stocks like those in Telecom and Utilities, but these sectors have outperformed the market by 16 percentage points, gaining 15.9%. The Goldman team expects the outperformance of Defensives stocks to continue for now, adding that about 60% of their mutual fund underweights and very important short positions are Defensives.
Large-cap core funds struggle, large core funds return solid performance
Kostin and team note that large-cap core funds have lagged the S&P 500 so far this year, dragged down by mutual and hedge fund favorites. Mutual funds are lagging the index by about 90 basis points, while hedge funds are even worse-off, lagging the benchmark index by 280 basis points
However, there is one bright area as they found that 32% of large core funds have outperformed the index so far this year. This is pretty close to the 33% average over the last decades. The Goldman team say also that large-cap growth funds have been performing the worst so far this year as only 9% of them have come out ahead of the Russell 1000 Growth Index year to date, highlighting just how much many of the major large-cap core hedge fund favorites are dragging down returns.
They add that usually a high return dispersion such as this can be related with higher opportunities in individual stock picking. However, they say that the “violent factor reversals” have made it extremely difficult for anyone to generate alpha thus far in 2016.
Momentum stocks cause problems for hedge funds
One big problem Kostin and team have found is that large-cap core mutual and hedge funds have been favoring momentum stocks, which has proven to be problematic because such a strategy has brought returns of -7% year to date. It’s understandable why momentum stocks have become key mutual and hedge fund favorites though as last year they surged 28%, but clearly some adjustments are needed now.
The Goldman team reports that mutual and hedge fund favorites have included high-growth consumer and technology stocks like Facebook and Google parent Alphabet. They add that the 11 stocks that are in both their mutual fund overweight basket and their hedge fund favorites basket have returned -10% year to date compared to last year’s 19% gain.