Over the last couple of years, value stocks significantly outperformed growth names, which caused serious problems for most equity-focused hedge funds. However, while some traders see potential pockets where value stocks can continue to outperform, some analysts believe the balance is about to shift back to the growth side of the equation.
In fact, the rotation from value back to growth is already occurring among some institutional investors. In its latest “Hedge Fund Trend Monitor,” Goldman Sachs reported that hedge funds had already started to rotate out of value stocks and back into growth during the fourth quarter.
However, BlackRock said this week that it sees pockets where investors might still be able to win with value stocks.
Value-to-growth rotation is already underway
According to Goldman Sachs, hedge funds started reversing from cyclical value sectors back to growth sectors in the middle of last year. At the beginning of 2023, information technology was the largest sector net exposure among hedge funds, at 21%, although they were still significantly net underweight on the sector, at -332 basis points.
On the other hand, healthcare accounted for 20% of hedge funds’ net exposure and was the largest overweight relative to the Russell 3000, at 487 basis points. Hedge fund and mutual funds are generally tilted toward the same sectors, although energy and financials are the exceptions. Mutual funds are overweight those sectors versus their benchmarks, while hedge funds are underweight relative to the Russell 3000.
Meanwhile, as part of their rotation back toward growth, hedge funds boosted their net tilt to consumer discretionary by 327 basis points, the largest change in any sector. Funds also increased their exposures to communication services and information technology. However, hedge funds slashed their net tilts to energy, industrials, materials and financials.
Goldman described the hedge fund rotation away from energy, industrials and material as “broad-based at the subsector level.” Funds cut their positions in six of the seven energy subsectors, 13 of the 25 industrials subsectors, and 15 of the 17 materials subsectors.
Meanwhile, they added to their positions in a wide variety of consumer discretionary subsectors. Among the consumer discretionary names with the largest increases in popularity among hedge funds during the fourth quarter were CarMax, Advance Auto Parts, Macy’s, Dick’s Sporting Goods, TJX Companies, Toll Brothers, Coupang, Wynn Resorts and Expedia.
Hedge funds boosted their consumer discretionary and communication services positions from almost the lowest tilts over the last 10 years to positions now ranking in the 41st and 31st percentiles.
The most popular hedge fund stocks
Thus far, it appears the rotation from value back to growth is benefiting fundamental, stock-driven hedge funds. Goldman’s basket of the most popular hedge fund positions has outperformed the S&P 500 year to date, rising 13% versus the index’s 8% gain.
This performance is in line with history, as the basket of the most popular hedge fund stocks has outperformed the index in 59% of quarters since 2001. It’s also particularly significant right now because the basket underperformed the S&P 500 dramatically in 2021 and 2022, lagging the index by 30 percentage points.
A review of the basket’s constituents reveals the extent of the value-to-growth ration. Four of the top five and eight of the top 10 positions are now technology or related names. The top 10 stocks are: Microsoft, Amazon, Meta Platforms, Alphabet, Visa, Uber Technologies, Apple, Netflix, Activision Blizzard and Mastercard.
Over the last two years, Goldman’s “Hedge Fund Trend Monitor” reports have shown steep declines in the stock prices of the most popular hedge fund stocks. However, this latest fourth-quarter report shows sizable year-to-date returns for many positions, including particularly large gains in Meta Platforms and Uber Technologies in the top 10 and, further down the list, NVIDIA.
BlackRock thinks value stocks can still outperform
Even as Goldman shares evidence of a massive hedge fund rotation from value back to growth, asset manager BlackRock states in its weekly commentary this week that it thinks value stocks can outperform even as interest rates continue to rise.
The firm did note that growth stocks have led the equity rally in the U.S. thus far, putting an end to value’s outperformance in 2022. However, the asset manager believes value stocks can resume their climb as the world’s major central banks keep interest rates higher for longer. The firm noted that higher rates reduce the value of future cash flows, which weighs more heavily on growth stocks and thus reinforces its underweight position on developed-market equities.
More generally, BlackRock’s sector and region preferences tilt toward value with quality attributes and “growth at a reasonable price.”
An atypical business cycle
According to BlackRock, the current regime isn’t a typical business cycle, so it requires a new playbook that’s also applicable to equity style factors. The firm noted that value stocks, or those seen as undervalued based on their fundamentals, lagged growth names over most of the last decade.
However, that changed abruptly when central banks started to tighten policy quickly. After a lengthy outperformance by value stocks, the factor dipped early this year as traders started to look for a shift from tightening back to easing. Nonetheless, the firm predicts a return to dominance for value, citing higher interest rates and inflation and a steeper yield curve.
The firm emphasized that trading is not about choosing one factor over another because different factors mean different things to different people, and the factor composition changes over time. For example, healthcare is now a modest overweight in the MSCI USA Value Index, although it was an underweight in 2008.
Go for value
However, the firm’s macro view suggests value over growth, given that higher interest rates feed into higher discount rates, making future cash flows less attractive. Aside from rapid revenue growth, one hallmark of the case for growth stocks is a focus on future cash flows.
Persistent inflation could lead investors to demand higher compensation for holding long-term government bonds, which should boost yields further. The firm noted that value tends to outperform during periods when the yield curve is steepening.
It added that value has historically underperformed going into a recession because capital-intensive companies can’t respond quickly to changing cycles. However, the asset manager thinks this time could be different because of the atypical economic cycle. The firm sees value as still attractive “after being beaten down for so long.”
Value companies have also had time to prepare for an extended downturn. Many banks have already set aside provisions for losses leading up to a recession. BlackRock expects a mild recession, so it thinks the impact to performance will be softe on value companies than it has been in past cycles.