Stock Pickers Just Suffered Their Worst Month in 20 Years

(Bloomberg) -- The renewed selloff in equities is offering bears a moment of vindication. But for professional stock pickers, the past month brought a reminder that being too defensive can be costly.  

The two-month stock rout at the start of the year sent actively managed funds pouring into cash and loading up on bearish wagers. The moves turned sour during the frenetic rally in the second half of March. As a result, long-only mutual funds trailed their benchmarks on average by a full percentage point last month -- the worst performance since 2002, data compiled by Bank of America Corp. show. 

Meanwhile, hedge funds that make both bullish and bearish equity bets also found themselves wrong-footed after slashing stock exposure to fresh lows. Forced to cover short positions as the market bounced back and then not adding longs, the group saw flat returns in the month through March 29, according to data compiled Goldman Sachs Group Inc.'s prime broker. That trailed the S&P 500's 5.9% gain over the same period. 

While all the defensiveness can be framed as a bullish sign for the market, the epic underperformance illustrates the challenges of navigating high volatility. Even if the rally was a bear market trap, as strategists from Morgan Stanley to BofA warned, it still brought pain for pros watching their returns languish.

“The magnitude of the rally in March was certainly beyond almost all expectations,” said Mark Freeman, chief investment officer at Socorro Asset Management LP. “Sentiment was very negative going in, especially with the first Fed rate hike on the horizon, which was reflected in the cash and low overall exposure.” 

Missing the mark was widespread: only 19% of long-only funds tracked by BofA beat their benchmarks in March. That's down from 45% in the first two months and the worst reading since 2010. 

While many factors may have contributed to the subpar performance, BofA strategists including Savita Subramanian and Ohsung Kwon pointed to two main culprits: elevated cash holdings and a reluctance to embrace energy stocks. 

In BofA's March survey of money managers, cash holdings rose to the highest level since April 2020. While such hoarding helps limit losses during a market retrenchment, it also caps the upside with cash yielding next to nothing. 

A persistent aversion to energy producers also hurt performance, as the industry has crushed the market every month this year. During the first quarter, active funds were 27% underweight energy, a stance that BofA estimates shaved 33 basis points off of returns.

The “March bounce left active behind,” Subramanian and Kwon wrote in a note. “All size and style segments lagged.” 

With the Federal Reserve embarking on a tightening cycle and the war in Ukraine still upending markets, going defensive looked like a sensible move to many investors. Yet to their surprise, stocks rebounded right as the central bank raised interest rates for the first time since 2018. 

Perhaps the gains owe to the Fed's resolve to tackle runaway inflation, or to a realization that stocks tend to do well in the early stages of a hiking cycle. Whatever the reason, the S&P 500 rose in 10 of 11 sessions, staging one of the biggest advances in a decade. 

The sudden rally was particularly painful for long/short hedge funds that failed to join the rally. In the final days of March, when retail investors rekindled dip buying in beaten-down names expensive tech stocks, the pros who had bet against these stocks in anticipation of higher rates were forced to cover their shorts, noted Goldman strategists led by David Kostin.

The same dynamic was seen on Morgan Stanley's trading desk, where long/short hedge funds kept selling last week, while retail money and computer-driven traders rushed to scoop up shares. 

“That demand is increasingly frustrating institutional investors, where U.S. L/S hedge funds sold longs and added to shorts,” Morgan Stanley wrote in a note. “March ended as one of the largest months of long selling from HFs in the last decade, and marked the second-worst Q/Q performance for U.S. L/S funds.” 

Granted, all the caution can mean potential dry powder to further lift the market. Analysts at JPMorgan Chase & Co.'s prime broker observed that the recent pattern of hedge funds selling into the rally echoed those seen around the market's troughs in December 2018 and March 2020. 

In those episodes, net flows turned more positive starting about a month after the market lows, providing additional fuel to share gains. It wasn't until fund positioning levels rose above above the historic average that the market saw a more meaningful pullback.  

The recent hedge fund selling into the stock bounce “may suggest, from a contrarian perspective, that equity markets could continue to grind higher,” JPMorgan analysts including John Schlegel wrote in a note. “That said, the macro backdrop is quite different from what it was in the prior episodes so it's certainly possible that this time will prove different and the upcoming earnings season could be critical for determining the medium term trajectory of markets.”

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