Goldman Explains Hedge Funds’ Reluctance in Rebound Rally

Hedge funds have largely refrained from participating in the recent market rally following the unwinding of the yen carry trade over the past two weeks, according to a new analysis from Goldman Sachs’ prime brokerage division.

Despite a strong rebound that has seen the Nasdaq 100 rise by 11% and the S&P 500 climb 8% since both indices hit multi-month lows on August 5, money managers have continued to reduce their exposure to equities.

Goldman Sachs reports that hedge funds are now on track to sell global equities at their fastest pace since March 2022, when markets were disrupted by Russia’s invasion of Ukraine.

“Despite the market’s recovery, gross and net leverage ratios have fallen in August, indicating a limited rebound in risk appetite after July’s significant de-grossing,” wrote Goldman Sachs analysts, led by Vincent Lin.

The current sell-off is primarily driven by short sales in the U.S. and long sales elsewhere, with net selling across both single stocks and macro products through August 21, the analysis reveals.

Bruno Schneller, managing partner at Erlen Capital Management, told MarketWatch that while there is broader market optimism, hedge funds remain cautious about the sustainability of the rally and are wary of potential headwinds.

Schneller pointed out that despite ongoing institutional inflows into U.S. equities, hedge funds appear to be hedging against downside risks and maintaining a cautious stance until there is more clarity in the economic outlook.

North America has seen the highest level of net selling this month, largely driven by short sales. In the U.S., hedge funds have been selling large-cap stocks while increasing their investments in small caps, according to Goldman Sachs. Meanwhile, energy, utilities, and real estate have been the most net bought sectors, signaling a shift toward high-dividend stocks.

Schneller also suggested that hedge funds’ caution may reflect concerns about the impact of potential Federal Reserve rate cuts and ongoing market volatility. He highlighted the elevated levels of the VVIX, which measures volatility in the VIX, along with heightened volatility in bond and forex markets.

“Hedge funds might be concerned that the market’s optimism is premature or that economic conditions could deteriorate before any rate cuts take effect, potentially leading to another downturn,” Schneller said.

Additionally, developed market Asia has been the second most sold region globally, following the largest 10-day cumulative sell-off of Japanese stocks in over five years, triggered by the unwinding of the yen carry trade. Emerging markets in Asia and Europe have also experienced net selling, driven by significant risk unwinds in China, South Korea, and Taiwan, as well as modest net selling in Europe.

“While the market’s surface-level optimism suggests a strong rally, underlying market stress and volatility are keeping hedge funds on edge,” Schneller concluded.