In 2022, the vast majority of hedge funds struggled to generate returns for their investors. As stock-picking funds generated negative returns, global macro funds came out the big winners. However, in 2023, it's looking like things could be turning around for stock pickers.
More Micro, Less Macro
Goldman Sachs reported in its recent "Hedge Fund Trend Monitor" that the average stock has become far less macro-driven in the last few months, suggesting an improving environment for alpha generation. The firm explained that recession fears and elevated volatility around interest rates combined to create a particularly macro-driven environment in 2022.
However, more recently, company-specific factors have driven an increasing share of stock returns. As a result, Goldman Sachs believes the unusually high gross exposures among hedge funds appear to be well-timed to take advantage of the current environment.
The firm added that rising dispersions in returns and tumbling stock correlations also suggest an improving environment for stock pickers. Much of 2022 was marked by below-average dispersions in returns and above-average stock correlations. However, all those measures have recently shifted back toward their averages over the last few decades.
Of course, absolute fund returns depend not only on alpha generation but also on managing market beta and other macro exposures. However, Goldman Sachs reported that after controlling for equity market betas, hedge funds generally tend to perform better during micro-driven return environments like the current one and the period in the mid-2000s. In 2022, macro factors drove most of the stock market returns.
Goldman Sachs estimated dispersion scores for every stock in the S&P 500 based on the macro- versus the micro-driven portions of their recent returns. The firm also modeled the volatility of future micro-driven returns to determine the S&P 500 stocks most likely to generate significant alpha in the coming months.Stocks that could generate significant alpha in 2023
According to Goldman, the stocks with the highest dispersion scores are likely to generate significant alpha, either through outperformance or underperformance. At the top of the list are:
- Enphase Energy (NASDAQ:ENPH)
- Moderna (NASDAQ:MRNA)
- Align (NASDAQ:ALGN) Technology
- First Solar (NASDAQ:FSLR)
- Bath & Body Works (NYSE:BBWI)
- SolarEdge Technologies (NASDAQ:SEDG)
- Tesla (NASDAQ:TSLA)
- Illumina (NASDAQ:ILMN)
- DexCom (NASDAQ:DXCM)
- Etsy (NASDAQ:ETSY)
Of note, Enphase Energy had plunged 23% as of the date of the "Hedge Fund Trend Monitor," although it has recovered slightly at a year-to-date return of around -15%. The only other stock in the top 10 that was in the red for 2023 at the time of the report was Moderna, which was down 4% for the year then but has since plummeted further, now off by 25% year to date.
At the other end of the spectrum were Tesla and Align Technology, up 64% and 55%, respectively, at the time of Goldman's report. Since then, Tesla has skyrocketed further and is now up 86% year to date, while Alight Technology has pulled back slightly but remains up 45% year to date.
One other noteworthy point is that hedge funds own 28% of Bed Bath & Beyond (NASDAQ:BBBY)'s market capitalization, the highest share by far of the top 10 on Goldman's list.
Of the 25 stocks on Goldman's list of the 25 most likely to generate significant alpha in the coming months, only Netflix (NASDAQ:NFLX), EQT Corp (NYSE:EQT). and Advanced Micro Devices (NASDAQ:AMD) were top positions among hedge funds as of the fourth quarter.
Other stocks of note on the alpha-generate list include Wynn Resorts (NASDAQ:WYNN), Generac Holdings (NYSE:GNRC), United Airlines, CarMax (NYSE:KMX), Las Vegas Sands (NYSE:LVS), and Caesars (NASDAQ:CZR) Entertainment.
Potential Alpha Opportunities in Spinoffs
Goldman Sachs also reported the "ongoing spinoff renaissance" could also provide alpha-generation opportunities for fundamental-driven investors. Last year saw 44 spinoffs announced, the second-highest total ever recorded, and Goldman expects spinoffs to remain popular this year.
The firm noted significant hedge fund ownership of many of the companies with pending spinoffs. For example, hedge funds own 22% of CommScope Holding (NASDAQ:COMM)'s market cap. General Electric (NYSE:GE), Vista Outdoor (NYSE:VSTO), and NCR (NYSE:NCR) Corporation each have two spinoffs pending, while Kellogg Company (NYSE:K) has three in the works.
Other stocks of note on Goldman's spinoff list include Johnson & Johnson (NYSE:JNJ), 3M Company (NYSE:MMM), Madison Square (NYSE:SQ) Garden, Danaher Corporation (NYSE:DHR), and Fidelity National Information Services.
Momentum Reversal
Another factor driving the resurgence in hedge fund returns has be a reversal in the momentum factor. Goldman Sachs highlighted the strong volatility in its "Hedge Fund Trend Monitor" for the previous quarter. That volatility transitioned at the beginning of 2023, becoming one of the sharpest monthly momentum reversals ever recorded.
Goldman's long/ short momentum factor plummeted 20% between the end of December and the beginning of February, marking a first-percentile drawdown since 1980. The firm explained that this magnitude of move typically characterizes recessions, although it also occurred during the tech bubble of the late 1990s and during the crash in 1987.
According to Goldman, the momentum reversal has also played a role in boosting hedge fund returns of late. In fact, hedge funds started 2023 with their long portfolios tilted further away from momentum than they have ever been in previous records.
Momentum Versus Value and Growth
The firm explained that funds' characteristic tilt toward growth and away from value largely explains this anti-momentum dynamic. According to Goldman's data, a tilt toward growth and away from value has been negatively correlated with momentum since value's outperformance over much of the last two years.
At the sector level, hedge funds have largely been pro-momentum toward the classical cyclical sectors, although they've been moving away from those sectors in recent quarters. At the time of the latest rebalance at the beginning of February, momentum had a large net tilt toward energy and away from information technology and communication services. That positioning is the opposite of recent sector rotations among hedge funds.
Goldman Sachs reported that momentum has generally tended to move sideways after other similar reversals in recent decades. The firm noted that momentum typically rebounds briefly immediately after sharp drawdowns, just as it has in recent weeks. Thus, history suggests another modest dip for momentum before a return to treading water.
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Disclosure: No positions