Currently, the index composed of the 30 most popular stocks among hedge funds is lagging behind the retail investor index by 289 basis points. This level of underperformance is on par with the initial stage of the stock market crash in March 2020, when the COVID-19 pandemic first hit.
Nowadays, the US stock market appears to have rebounded significantly, but in reality, the rebound is extremely uneven.
Thirty stocks that are favored by hedge funds have soared by 30%. However, the "retail investor group stocks" that are shorted by institutions but sought after by individual investors have risen even more.
Almost all hedge funds engage in pair trading, which provides funding for their net exposure, meaning that most long positions are offset by short positions. The problem is that although the long positions have risen significantly, the stocks that have been shorted the most have seen much larger gains. It is not difficult to see that among these stocks that are most favored by hedge funds, if we exclude the stocks that have been shorted the most, the index of stock selection by hedge funds has fallen by 8% this year, and the decline has been rapid.
This means that although a few artificial intelligence-related stocks have performed well this year, the rest of the stocks typically chosen by hedge funds have been a complete disaster.
On Wednesday, the retail investor group stock Carvana canceled its forward performance guidance and announced a major debt restructuring plan. Surprisingly, this move caused the stock to soar, leading to a 629 basis point increase in the retail investor group stock index on that day. By Thursday, the index composed of the 30 most favored stocks by hedge funds lagged behind the retail investor group stock index by 289 basis points.
Investors can pay attention to the changes in the difference between these two indices as an indicator of the level of risk exposure for hedge funds and its relative relationship with the historical performance of the US stock market. The last time the difference between the two was this large was in March 2020, at the beginning of the COVID-19 outbreak when the market lost confidence in the US stock market and it experienced consecutive days of plunging.
One interpretation of this is that as hedge funds rush to extract the last bit of collateral by pushing their total risk exposure to unprecedented levels in order to maintain the same net risk exposure, the overall leverage ratio is now actually very high. Some analysts believe that this will become a problem for the current US stock market because if there are issues with long-term trades in popular hedge fund strategies (i.e., if the artificial intelligence bubble bursts), it will be a historic stock market bubble burst.