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Hedge Funds May Be Scenting Market Turn

Date: Friday, February 8, 2008
Author: Jeremy Gaunt, Reuters.com

LONDON (Reuters)—If hedge funds are, as is often claimed, the investment vanguard, their latest moves appear to be telling financial markets it is time to take a break from the trading patterns that have dominated since mid-2007.

Investment banks have been poring over the latest data on hedge fund positioning from the U.S. Commodity Futures Trading Commission and concluded that a number of speculative bets have been changed. Société Générale, for example, says long positions on 10-year government bonds have been closed. That is to say, hedge funds are not expecting demand for such bonds to increase and drive yields lower.

Similarly, hedge funds have sharply cut back their long euro-dollar holdings, meaning they now expect the dollar to strengthen or at least stabilize against the single currency. As for equities, recent moves would also seem to be good news for those yearning for a return to the bull market.

"Confirmation of further policy action to reflate economic growth has led to a significant reduction of shorts on the S&P 500 and an increase of shorts on volatility," SocGen said in a note. In other words, hedge funds have stopped betting that the broad U.S. stock index will fall and are now betting that volatility, or sharp moves on the index, will ease off.

"Once you get a 75-basis-point rate cut from the Fed with the promise of more to come ... most traders don't want to bet against that," said Edward Hands, senior portfolio manager for alternative investments at Comas, part of Commerzbank Corporates and Markets. He was referring to the emergency rate cut by the U.S. Federal Reserve on Jan. 22 that helped cement in many investors' minds the belief that monetary authorities will come to the rescue of markets in turmoil.

Caution Remains

The significance for many investors is that hedge funds often blaze the way on markets, either by taking bets more mainstream funds are not willing or able to take, or by moving the markets themselves with their bets. The CFTC figures, for example, show that hedge funds began betting against the S&P 500 in June last year. Since then it has fallen as much as 17%.

Similarly, they began buying the euro in early 2006 when it fetched around $1.18. It was around $1.46 on Thursday [Feb. 7]. But before jubilation sweeps across markets that hedge funds have signaled a turn—ending months of tumbling equity markets, lower bond yields and a weaker dollar—it is worth noting that not everything has changed.

The same CFTC data shows the funds remain massive net sellers of the Russell 2000 index of mainly small U.S. stocks. At the same time, the number of hedge funds long on gold is at an all-time high. Both these positions would argue for hedge funds banking on more financial turmoil ahead. Spot gold, after all, is at record highs, driven by investors seeking safety in times of trouble.

Similarly, while hedge funds have become more positive about the dollar against the euro, they have been selling the U.S. currency against both the Japanese yen and Swiss franc. Both currencies are currently viewed as safety plays.


There is little doubt that hedge funds betting on market direction, sometimes called macro strategy, have benefited from the turmoil seen over the past half-year. Return figures for January are not yet available but the trends from last year should have carried over.

The Credit Suisse/Tremont hedge fund index for macro strategies, for example, shows returns of 17.4% in 2007, 1.5% of it coming in December. So some of the recent moves could reflect a desire to lock in those profits.

"It is more likely to be the direction managers who have had a very good run in January and have taken some risk off the table," said one hedge fund specialist at an investment bank. The specialist, who asked not to be identified, suggested there may now be a bit more emphasis on selection—stock picking and the like—rather than directional plays.

Taking a bit of risk off the table to protect returns would seem natural.

But extreme positions such as those held in gold and against the Russell 2000 do sometimes presage a sharp turn. And pulling back on S&P 500 shorts and long-bond longs is significant given the trend up to this point.

Investors yearning for an end to the recent turmoil will be hoping so, anyway.

By Jeremy Gaunt