Hedge Funds Buying as Individuals Sell in Bull Signal

Date: Tuesday, December 1, 2009
Author: Lynn Thomasson and Mary Childs, Bloomberg.com

Hedge funds are shoveling money into stocks as individuals exit at the fastest rate in a year, a sign to professional investors that the Standard & Poor’s 500 Index is poised to extend its gains.

About $37.3 billion has been pulled from U.S. mutual funds since August, according to the Investment Company Institute. Hedge funds -- which lost half as much on average as the S&P 500 since stocks peaked in October 2007 -- boosted bets to the highest level since the end of that year in the third quarter and have kept buying, according to data compiled by Goldman Sachs Group Inc., industry consultants and Bloomberg.

“The more sophisticated investors are seeing the opportunity, but retail investors are still scarred,” said James Dunigan, the Philadelphia-based chief investment officer for the wealth management division at PNC Financial Services, which oversees $104 billion. “It suggests that the rally still has room to go.”

Before credit markets started to freeze in August 2007, the last time mutual funds saw outflows this big was in the nine months up to February 2003, just as the S&P 500 began a five- year rally. Now, the sales are offering opportunities to Paulson & Co., Christofferson Robb & Co. and Passport Capital Management LLC to bet the more than $11 trillion lent, spent or guaranteed by the U.S. government to end the recession will lift stocks.

Individuals, who account for 82 percent of mutual fund owners, took $21.4 billion more out of equities than they’ve added and put $312.8 billion into bonds this year through the end of October, according to Washington-based ICI.

Bearish Bests

Investments designed to profit when stocks retreat increased. So-called bear-market and long-short mutual funds attracted a record $10 billion this year through October, more than double the previous high in 2006, according to Morningstar Inc. So-called retail managers have opened 19 long-short funds, the most in a year.

By contrast, hedge funds raised their stakes by 21 percent to $604 billion in the third quarter, according to Goldman Sachs. They held $363 billion in short sales, or bets that stocks will drop, the data show. The funds now own 3.8 percent of the Russell 3000 Index, which includes the largest American companies, the highest percentage this year.

Hedge funds, mostly private pools of capital whose managers participate substantially in the profits from speculating on whether the price of assets will rise or fall, got $1.1 billion of net investments in the three months through September, according to Chicago-based Hedge Fund Research Inc. The increase was the first in a year for the $1.53 trillion industry.

March Rally

The S&P 500 advanced 15 percent in that period and has rallied 62 percent since reaching a low on March 9, for a 2009 return of 24 percent including reinvested dividends. The gauge added 0.4 percent to 1,095.63 as of 4 p.m. in New York.

“It makes sense hedge funds are getting long given that the market’s up so much in a six-month period,” said Harry Rady, who oversees $250 million as chief executive officer of Rady Asset Management LLC, a La Jolla, California-based manager whose hedge fund has been adding to stocks. “The Fed has said they’re not going to let the market go down and they’ve done it by pumping liquidity into a variety of markets and that’s spilled into the equity market. People have the confidence to take equity risk.”

Most U.S. stocks fell last week as speculation Dubai may default spurred concern that the recovery in the global financial system will stall, overshadowing fewer American jobless claims and increasing home sales. The Dow Jones Industrial Average slipped 0.1 percent to 10,309.92, while 273 companies in the S&P 500 declined compared with 224 that rose.

Buying Stock

Managers added to stocks in the last two months, according to London-based investment adviser Kinetic Partners, which includes two-thirds of the 50 largest U.K. hedge funds as clients, and Conifer Securities LLC in San Francisco, which executes trades for more than 100 of the firms.

About 900 went out of business during 2008 as the S&P 500 fell 38 percent, the steepest drop in seven decades, according to data compiled by Hedge Fund Research and Bloomberg.

Hedge fund assets may increase to $1.75 trillion by the end of 2010, Morgan Stanley’s Huw van Steenis wrote in a Nov. 23 report. Peter Clarke, chief executive officer of Man Group Plc, the biggest publicly traded hedge-fund manager, said in a meeting with reporters Nov. 23 that he expects the industry to receive as much as $50 billion a quarter next year.

New Cycle

“The whole idea of hedge funds is very flexible: you can use your initiative to back the horse that’s winning this particular race and then move on,” said Andrew Shrimpton, a hedge-fund adviser at Kinetic. “It’s the beginning of a new cycle, really. Money’s starting to flow in and there is ability to leverage up on that money especially if the collateral is liquid collateral such as equities.”

Stock speculation is increasing after the Federal Reserve held its target rate for overnight loans between banks near zero since December. Three-month dollar Libor, a benchmark for lending by brokerages for stock purchases, fell to a record low of 0.254 percent this month.

Equity buying by hedge funds may be less bullish because managers are using options, short sales and credit-default swaps to protect their investments, according to Mark Yusko, president of Morgan Creek Capital Management LLC, an adviser to funds of funds in Chapel Hill, North Carolina. The Chicago Board Options Exchange Volatility Index, based on prices paid to insure against losses in the S&P 500, slipped to 20.05 last week, the lowest level in 15 months, before jumping to 24.74.

Shorting, Options

“Yes, hedge funds are buying stocks, but they’re also shorting stocks in record numbers and buying put options in record levels,” Yusko said in a telephone interview. “It basically neutralizes a lot of their equity exposure.” Puts are options that pay off when a stock, commodity or index declines.

Short interest on the New York Stock Exchange jumped in March and remains above historic levels. Stock sold short equaled 3.51 percent of shares outstanding at the end of October, or 40 percent above the average this decade.

“Most of the managers we know think the rally’s far overextended, that equities are way overpriced, and that they’re due for a very significant, long correction,” Yusko said. Morgan Creek manages about $9 billion for institutions and wealthy clients.

Valuations

The S&P 500 traded last week for 21.9 times the past year’s earnings from its companies, the highest since 2002. The Labor Department may say on Dec. 4 that the U.S. unemployment rate held at 10.2 percent this month, according to the median estimate of 65 economists surveyed by Bloomberg. A report this week is projected to show growth in construction spending slipped.

Paulson, the hedge-fund manager whose wagers against the U.S. housing market helped him earn an estimated $2 billion last year, bought Bank of America Corp. stock in the second quarter, while adding to stakes in gold companies. Charlotte, North Carolina-based Bank of America has climbed 127 percent since the end of March, according to data compiled by Bloomberg.

Paulson told investors in a quarterly letter this month that he expects Bank of America stock to almost double in the next two years as writedowns ease.

Christofferson’s Brad Golding, whose CRC Financials Opportunities fund beat 95 percent of its peers in 2008 with a 109 percent gain, said he bought shares of Oppenheimer Holdings Inc. because the firm trades below book value, or the cost of its assets. The New York-based brokerage has rallied 23 percent since the end of the third quarter.

Favorite Stocks

Pfizer Inc., Bank of America and Apple Inc. ranked as the most popular stocks among hedge funds with more than 147 owning shares, according to Goldman Sachs’s survey of 13F regulatory filings. New York-based Pfizer, the world’s biggest drugmaker, added 45 percent since the S&P 500 fell to a 12-year low on March 9, while Cupertino, California-based Apple, maker of the iPhone, surged 141 percent.

“This is a phenomenon that should continue into next year and perhaps far into next year,” said John Burbank III, the chief investment officer of Passport Capital, a $2.1 billion hedge-fund firm in San Francisco that began adding shares halfway into the rally. Individuals “may never believe in equities again, we don’t know,” he said. “But hedge funds are generally increasing, partly because they’ve been conservative, and partly because they see opportunities to make money.”

To contact the reporters on this story: Lynn Thomasson in New York at lthomasson@bloomberg.net; Mary Childs in New York at mchilds4@bloomberg.net.