The Wall St. sign is seen near the NYSE in New York
The Wall St. sign is seen near the New York Stock Exchange (NYSE) in New York City, U.S., May 4, 2021.

Still uncertain on where U.S. stocks are headed, equity hedge funds are sitting out the market rally despite taking big paper losses on bearish bets since June, according to industry executives and market data.

After slumping more than 20% during the first half on worries aggressive U.S. Federal Reserve rate hikes aimed at taming inflation may cause a recession, the S&P has rebounded 17% since mid-June on signs prices may be stabilizing.

However, hedge funds have remained on the sidelines of the rally to assess more economic indicators before re-calibrating their portfolios, said prime broking executives and fund managers.

In a sign of their dim view of the market, hedge funds are sitting on a record $107 billion worth of net short positions - or negative market bets - in S&P 500 futures, according to BNP Paribas calculations based on regulatory data from last week.

That skepticism among sophisticated investors with $1.1 trillion in assets globally suggests the rally could be short-lived, according to prime brokers.

"This is probably one of the most disliked rallies in the market across all client segments," said a prime broker at a Wall Street bank, noting funds have been selling long positions into the rally. "The first week of August was one of our largest de-risking weeks we've seen in the last five years."

Stocks are rallying largely because some investors believe the Fed will pull back on tightening monetary policy sooner than previously expected, although Fed officials aren't making that promise.

Not all bearish hedge funds have been able to maintain their short positions, and some of the market's recent gains have likely been fueled by investors unwinding or "covering" those bearish bets, the people said. That process involves buying back stocks the funds had borrowed to sell short.

NOT A GREAT SIGN

"There was a lot of coverage by hedge funds while the market went up," said Kris Kwait, chief market strategist at Commonfund, an asset manager which invests in hedge funds.

Kwait added that the fact hedge fund covering appeared to be driving the rally was "not a great sign" for its sustainability.

When the rally gained steam in July, hedge fund sales of long positions and purchases to cover short positions in non-essential consumer goods stocks, for example, were among the largest in the past five years, according to Goldman Sachs data.

Max Grinacoff, U.S. equity and derivatives strategist at BNP Paribas, said short covering continued in August, and last week "in particular", after Wednesday Consumer Price Index data suggesting inflation may have peaked sent stocks higher.

Since June 16, short sellers have suffered unrealized losses of $174 billion, although they are still up $162 billion in unrealized gains this year, according to financial analytics firm S3 Partners.

Equity positioning for institutional investors as a whole has crept up in recent weeks but remains in the 15th percentile of its range since January 2010, meaning it has only been lower 15% of the time over the past 12 years, according to an Aug. 13 note by Deutsche Bank analysts.

Amid macroeconomic uncertainties, hedge funds have significantly reduced their overall risk this year. Equity long-short hedge funds' net leverage was 48% at the end of July compared with almost 70% in January, according to a Goldman Sachs' report.

Hedge fund portfolio managers will likely reassess their strategies next month, when liquidity is set to increase as the summer break ends and more economic data is available, two prime broker executives said.

"Investors might still be bearish on the overall outlook," said BNP Paribas' Grinacoff. "But to the extent they're getting caught offside, they may need to either cover or potentially participate in the upside rally."