Why Hedge Funds May Still Have More to Contribute to a Stock Sell-Off

The S&P 500 is down about 3.7% year-to-date as of market open on Dec. 17, 2018. Market analysts have begun to very vocally sound the alarm about the possibility of a bear market — but if you listen close enough, you'll also hear whispers about a looming recession. There are certainly ways that investors can protect themselves against potential losses in the event of a market downturn. Still, market capitulation, or the phenomenon in which investors give up earlier gains when they sell off their positions out of panic, remains a real possibility. To make matters worse, it could be some of the biggest players in the financial world — hedge funds — who end up leading the trend.

Where Do Hedge Funds Piece Into a Market Sell-Off?

Hedge funds could contribute to a prolonged stock sell-off into the future. According to a recent report by Bloomberg, Sundial Capital Research found that hedge funds as a group bought heavily into American equities, and moreover that many of these funds are still quite strongly invested in U.S. names. Specifically, the report notes, long-short equity hedge fund exposure to the S&P 500 Index has dropped significantly from its high several weeks back in October, but it remains above comparable market lows in the past decade or so.

Sundial Capital Research president Jason Goepfert suggests that, while "hedge funds are fleeing stocks," they're not doing so quickly enough. Goepfert adds that hedge fund "returns are still showing consistently positive correlations to movements in the S&P 500, suggesting they haven't reduced their exposure much despite the volatility."

Is It Still Too Soon to Tell?

Hedge funds have taken approaches ranging from cautious to innovative in recent years, as many players have faced significant barriers to generating positive returns. The group of funds faced its worst year since 2011, and hedge fund managers have only recently started to return to stocks in a significant way, reflected in the increased risk appetite marked by a boost to gross leverage across the hedge fund industry, per the report. All told, hedge funds reached a record high exposure to the S&P 500 in September.

U.S. stocks have fallen, in some cases precipitously, in the past several weeks and for a variety of reasons: increased skepticism about growth outlook, prolonged trade tensions between the U.S. and China, and anxiety over other geopolitical concerns. It may be difficult to say for the time being how hedge funds have reacted to the shift in S&P fortunes, as comprehensive data about fund equities holdings will not be available until after the conclusion of the quarter.

Some analysts believe that market capitulation is a sign that a downturn has reached its lowest point. When sellers give up on their holdings, opportunistic buyers see the chance to buy up stakes at bargain prices. From another perspective, though, the longer that hedge funds hold equities, the lengthier the downturn is likely to be. Still, a Nov. 30 report by Institutional Investor notes that fund managers including Daniel Loeb of Third Point and David Tepper of Appaloosa Management have trimmed their equities exposure in 2018 by a sizable margin (in Tepper's case, by about $3 billion, or a third of his fund's total equities portfolio value). Whether funds like these have more room and desire to sell or not will likely have an impact on the future of everyday investors as well.