Narrow market proving a headwind for mutual funds, opportunity for hedge funds

Goldman Sachs is the latest Wall Street bank to weigh in on the narrowness of the 2023 rally that has brought the S&P 500 nearly 300 points above their year-end target.

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Goldman has a 4,200 target for the S&P (SP500) (NYSEARCA:SPY) (IVV) (VOO) for the end of this year. 

But its equity team notes that investor enthusiasm “about the potential benefits to companies from AI has lifted the index … despite uncertainty on the timing and magnitude of the adoption of AI.”

“The seven largest constituents have surged 53% vs. just 0% for the remaining 493 stocks,” strategist David Kostin wrote in a note.

Nvidia (NVDA), Alphabet (GOOGL) and Microsoft (MSFT), “which our analysts view as leading beneficiaries of the AI revolution, have soared by 172%, 40%, and 39% YTD,” Kostin said. “Excluding these 3 stocks, the S&P 500 P/E multiple would be 1x lower and closer to our forecast than at the current valuation of 18x.”

Hedge funds and mutual funds have lagged the S&P’s 12% year-to-date performance. Long/short equity hedge funds are up 3% and the average large-cap mutual fund is up 7%.

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Mutual fund challenges

“The market’s extremely narrow YTD rally has been a significant headwind to mutual fund performance,” Kostin said. “The largest tech stocks (Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA), Meta (META)) have returned 53% YTD vs. just 0% for the remainder of the S&P 500.”

“The average large-cap mutual fund is 721 bp underweight this group of stocks, which was the major contributor to mutual fund underperformance. The largest tech stocks were a 236 bp drag on the performance of the portfolio of the average mutual fund relative to the Russell 1000 (NYSEARCA:IWB). Excluding the largest tech stocks, the portfolio of the average mutual fund outpaced the Russell 1000 index by 36 bp.”

“The average large-cap growth fund holds a 27% weight in these 7 stocks, 15 pp lower than the staggering 42% weight of these stocks in the Russell 1000 Growth index (NYSEARCA:IWF),” Kostin said. “SEC diversification requirements prevent many growth funds from holding benchmark weights in these stocks.”

“The average growth fund in compliance with diversification requirements trails the Russell 1000 Growth index by 7 pp YTD (14% vs. 21%). However, growth funds in violation of SEC diversification requirements are outpacing the growth benchmark by 1 pp on average (22% vs. 21%).” 

Hedge fund tailwinds

“In contrast, mega-cap tech has been a performance tailwind for hedge funds,” Kostin said. “The largest tech stocks have been long-standing favorite long positions among hedge funds.”

“MSFT sits atop our list of Hedge Fund VIPs, followed by AMZN and META,” he said. “Other mega-cap favorites, including GOOGL, AAPL, and NVDA, rank among the 10 most important holdings. Our Hedge Fund VIP basket has outperformed the S&P 500 by 5 pp YTD (17% vs. 12%). But index hedges and a record overweight tilt in Health Care (-5% return YTD) have detracted from hedge fund performance.”

“Hedge funds cut their exposure to Info Tech by 538 bp and became incrementally more underweight in 10 of the 12 subsectors relative to the Russell 3000 (NYSEARCA:IWV). The seven mega-cap tech stocks accounted for 10% of hedge fund long equity assets at the start of 2Q 2023, the largest share since at least 2007. However, META, AAPL, and MSFT were among the TMT stocks with the largest net decrease in hedge fund ownership during 1Q.”

Picks and pans

These stocks cross over with Goldman’s hedge fund and mutual fund baskets.

Hedge Fund VIP List Long Positions and Mutual Fund Overweights:

  • Fiserv (FISV)
  • Humana (HUM)
  • Mastercard (MA)
  • ServiceNow (NOW)
  • Palo Alto Networks (PANW)
  • Uber (UBER)
  • UnitedHealth (UNH)
  • Visa (V)
  • Workday (WDAY)

Hedge Fund VIP List Short Positions and Mutual Fund Underweights:

  • AbbVie (ABBV)
  • Boeing (BA)
  • Costco (COST)
  • Chevron (CVX)
  • Disney (DIS)
  • Ford (F)
  • Home Depot (HD)
  • IBM (IBM)
  • Intel (INTC)
  • Johnson & Johnson (JNJ)
  • Coca-Cola (KO)
  • McDonald’s (MCD)
  • Moderna (MRNA)
  • Realty Income (O)
  • PepsiCo (PEP)
  • Pfizer (PFE)
  • Procter & Gamble (PG)
  • Starbucks (SBUX)
  • Thermo Fisher (TMO)
  • Tesla (TSLA)
  • Verizon (VZ)
  • ExxonMobil (XOM)

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