Hedge funds are “swimming in the deep end of the pool” this year, according to J.P. Morgan Asset Management’s Michael Cembalest, who pointed out several “warning signs” to consider when looking at the sector.
In a recent review of alternative investments, he said these funds are showing “record levels of crowding, concentration, and high beta exposure.” Leverage, by some estimates, has also skyrocketed.
The good news is that “diversified hedge fund portfolios still outperform risk-adjusted benchmarks,” said Cembalest, chairman of market and investment strategy at J.P. Morgan Asset Management.
In fact, hedge funds are showing their strongest performance gains in years, with Hedge Fund Research reporting that the industry’s more than 10 percent gains this year through October are its highest since 2021. With investors putting $71 billion into hedge funds through September, the alternative strategy is likely to end the year with its biggest influx of cash since 2014, having already reached nearly $5 trillion in assets, according to HFR.
While only 30 percent of hedge funds outperform a 70/30 mix of equities and fixed income, Cembalest noted that the latter had significantly higher volatility.
Despite this, Cembalest identified a few potential areas of concern. For example, he cited Goldman Sachs research showing that hedge funds have about 15 percent of their portfolios invested in the so-called Magnificent Seven stocks: Apple, Amazon, Google, Meta, Microsoft, Nvidia, and Tesla. That compares with about 5 percent in 2018, a percentage that has risen along with those stocks’ weighting in the Russell 3000 index, which is now about 30 percent.
Moreover, hedge funds are crowding into the same stocks at a level not seen in years. In 2006, Goldman found about 10 percent of “distinct equity holdings” by hedge funds. The level of crowding has continued to grow, with less than 4 percent in that category today.
Cembalest noted that the average hedge fund holds 70 percent of its long portfolio in ten positions — “closest to the highest concentration on record.”
Another warning sign he mentioned is that fundamental long-short hedge funds “have shifted portfolios to stocks in the highest quintile of beta, which are generally AI-related stocks.”
Meanwhile, hedge fund leverage has been growing. According to the April global financial stability report of the International Monetary Fund, macro funds were levered 45 times capital, the most of any strategy. Relative value was next at 25 times capital. Both of those strategies had 15x leverage ten years ago.
That way of measuring hedge fund leverage “includes the ratio of long and short positions divided by net asset value, and net leverage divided by net asset value,” Cembalest explained. He cautioned, however, that the calculation doesn’t capture everything as funds can access leverage through different vehicles, including futures or repos.
In fact, another J.P. Morgan team writes a flows and liquidity report to estimate the implicit leverage and risk of hedge fund positions. Using that analysis, Cembalest said, “hedge fund leverage is comparable to prior periods and not unusually high.”
