AI is making hedge funds unable to hedge
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The concentration of market gains into a basket of AI stocks ($5 trillion Nvidia mainly) is making it harder for hedge funds to hedge, as they are becoming dangerously correlated with the broader stock market.
Why it matters: Higher correlations increase the chance of bigger losses when there is a downturn, defeating the primary purpose of hedge funds.
What they're saying: "A lot of investors are going to be caught surprised," Jon Caplis of PivotalPath, which tracks data from more than 3,000 hedge funds, tells Axios. "It turns out that they had a lot more exposure to just traditional equity markets than we thought."
- "When everything's going well, that may be OK," he says, but "when things do turn around, which at some point they will, that disconnect is going to leave a lot of investors caught off guard, which is never a good thing."
By the numbers: Hedge funds move more like the stock market more than ever.
- The 12-month correlation between composite hedge funds and the S&P 500 is 0.955, at the 99th percentile of historical readings. Multi-strategy hedge funds show a 0.819 correlation, also near a record high at the 98th percentile.
- That means hedge fund returns are tracking the broader market far more closely than usual, offering their investors less diversification.
- The shift suggests funds are crowding into similar trades.
Between the lines: The culprit is market concentration within the AI trade.
- Nvidia alone is "influencing trillions of dollars in active management" across hedge funds and across asset classes, Caplis says.
Yes, but: The largest hedge funds are more likely to have bigger investment teams and more diverse strategies to make sure they can deliver returns that are not so correlated to the stock market.
- But for second- and third-tier hedge funds, they may be more complacent, happy to ride the AI wave even if it now delivers highly concentrated and correlated returns.
- "Not every investor is going to really nitpick over what is exactly alpha and is correlated versus what is absolute return," Caplis says.
The bottom line: Hedge funds may have to figure out how to hedge in an AI world before clients start wondering why they pay 2% management and 20% performance fees.
