Hedge Fund Bets Mirror Dotcom Bubble, Only Much Bigger

Huge flows of money from hedge funds may be helping to create dangerous speculative bubbles, according to strategists at French-based multinational banking and financial services giant Societe Generale, as reported by Business Insider. These speculative bets, Societe Generale warns, "bear a worrying resemblance to the dotcom bubble." They fall into four main areas, as summarized in the chart below.

Hedge Funds: Big Speculative Bets In Four Areas

Source: Societe Generale, as reported by Business Insider

What Should Concern Investors

For a variety of reasons, hedge funds were widely expected to shine this year. The factors supposedly in their favor included an uptick in market volatility and the fact that hedge funds can profit in flat or down markets by engaging in short sales of specific stocks. Instead, the average gain for hedge funds during the first half of 2018 was a paltry 0.81%, less than half the 1.67% advance for the S&P 500 Index (SPX), according to analysis by Hedge Fund Research Inc., also known as HFR, as reported by The New York Times.

Hedge funds have increased their total assets under management (AUM) for eight consecutive quarters, each time setting a new all-time record. As of the end of the second quarter the global figure was $3.235 trillion, HFR reports. The second quarter of 2018 saw the first quarterly net outflow, equal to $3.0 billion, since the first quarter of 2017. Despite nearly a decade of underperformance, hedge funds nonetheless have continued to grow through large infusions of new capital from hopeful investors, the NYT indicates. (For more, see also: Why Stocks Are in a Hidden Bear Market.)

Observing that the hedge fund industry "is crowded with managers struggling to justify their costs," Bloomberg notes that it lost a record 19% on average in 2008. Meanwhile, the few managers who made names for themselves during the financial crisis by delivering gains or by issuing prescient warnings, such as David Einhorn, John Paulson and Alan Howard, largely have been underperformers since then.

Contrarians are apt to view the big bets being taken by hedge funds as signs of an overall market downturn to come, especially given these funds' extended period of poor performance. The four big bets are discussed in more detail below.

Short volatility. On Feb. 5, an unexpected spike in the CBOE Volatility Index (VIX) produced severe losses for traders who had been betting on continued low volatility. For some, many months of prior gains were wiped out, and several investment products designed to profit from low volatility lost virtually all their value and had to be liquidated, as CNBC reported. Apparently having forgotten the lesson of Feb. 5, hedge funds now have short positions on the VIX that are near historically high levels.

Long stocks. Hedge funds have a net long position in stocks, despite concerns in many quarters about high valuations that are likely to crumble once the economy and earnings growth stall. Societe Generale calls this bet on stocks to be "uncomfortably high," given their own forecast that the S&P 500 will sink to 2,200 by the end of 2019, down almost 24% from today.

Long oil, short gold and the Swiss franc. The price of oil is at a four-year high, and threats of U.S. sanctions on Iran may send it yet higher. However, Societe Generale does not see oil as an attractive buy right now. Nonetheless, hedge funds remain net buyers of oil, while taking short positions in safe haven assets such as gold and the Swiss franc. (For more, see also: 4 Top Low Volatility Stocks for 2018.)

Short U.S. T-Notes. Hedge funds have taken large short positions in 5-year and 10-year U.S. T-Notes, apparently based on expectations of continued robust U.S. economic growth that will propel interest rates yet higher. However, Societe Generale expects U.S. GDP growth to slip to 1.6% in 2019, below the consensus forecast of 2.5%. "With a U.S. yield curve as flat as a pancake to begin with, and the given the expectation of another Fed rate hike later this year, an inversion of the yield curve strikes us as a more likely scenario [than increased longer-term rates]," they write.

Looking Ahead

If hedge funds start posting big losses on these bets, that may prompt a wave of redemptions by investors, producing yet more losses. Accordingly, investors should approach hedge funds with caution, understanding fully their investment philosophies and what big bets they may have in place, before committing capital to them.