As the name suggests, hedge funds are supposed to do one thing really well: hedging. That means they should be able to successfully take opposing long and short positions, designed to protect their positions and enhance their returns under any market conditions. So given today’s challenging investing environment, it feels like prime time to take a peek at Goldman Sachs’s latest deep dive into hedge fund activity. I’ve summarized what the big bank found out, so let’s get going.

1. Hedge funds have done better on average than the S&P 500 this year.

Goldman’s hedge fund report analyzed 786 hedge funds with $2.3 trillion of stock investments between them – that’s $1.5 trillion long and $730 billion short. The average hedge fund has made a 1% return since the middle of the year, and is down 5% so far this year. And while that might not sound amazing, that’s still 11 percentage points better than the S&P 500’s 16% dip. Hedge funds that trade based on global macro trends have done even better, chalking up a 9% gain this year: after all, they’ve had a whirlwind of opportunities ranging from geopolitical volatility to central bank rate hikes to inflationary concerns – and that’s only the half of it.

Year-to-date returns of various assets. Sources: HFR, FactSet, Goldman Sachs Global Investment Research

2. Hedge funds have reduced their risk.

Let me introduce you to the “net leverage” metric: the difference between the amount hedge funds are spending on long and short bets. The lower the net leverage, the less risk they’re taking on. The metric’s currently hovering near the levels we saw during the Covid crash around March 2020. In fact, Goldman’s data shows that it’s at the 18th percentile when measured against the past five years, and the 14th against the last year. Now if history repeats itself, hedge funds may well start taking on more risk – you’ll be able to tell if their net leverage starts creeping upward. But if the S&P 500 takes a turn for the worse, they’re unlikely to take on more risk in the short term.

Gross and net exposure of hedge funds since 2016. Sources: Goldman Sachs Prime Services, Goldman Sachs Global Investment Research

3. Here's how hedge funds are investing.

Hedge funds have turned their back on “momentum strategies” – that’s when you generally trade alongside the markets' sustained price trend – so far in the final quarter of 2022. Momentum-based strategies generally outperform during periods of market stress like in 2009, 2012, 2016, and 2020, and since hedge funds’ low net leverage hints that they have doubts about the markets’ movements, refusing to follow market price trends could make sense.

And while hedge funds usually go for more growth stocks, they’ve held more value stocks than usual over the past year. But because growth stocks did well during the third quarter, hedge funds picked up enough of them to bring the balance back toward the 20-year average.

Hedge funds didn’t play around with their sector allocation much over the third quarter, but they did shift away from consumer discretionary stocks (that’s firms that make nice-to-haves) and toward consumer staples (that’s firms that make stuff folk need no matter what). They also added more energy and materials stocks to their roster. Information technology stocks still make up the thickest proportion at 21%, but that’s lower than their weighting in the Russell 3000 index. The main takeaway here is that hedge funds are allocating more capital to defensive sectors, based on their returns so far this year: that includes consumer staples, utilities, energy, materials, and industrials, which are all outperforming the Russell 3000 index’s 17% loss so far this year.

Sector changes from Q3 to Q4 2022, as well as year-to-date returns. 100bp = 1 percentage point. Sources: FactSet, Goldman Sachs Global Investment Research

4. Hedge funds’ most popular stock picks.

Now let’s check out which specific stocks hedge funds have been picking. The “Hedge Fund VIP List” contains the 50 stocks that appear most frequently among hedge funds’ biggest 10 holdings. Microsoft was crowned champ, toppling Amazon off its throne. Netflix and Uber moved into the top five, while Meta was shunned by investors and fell out of the grouping for the first time since 2014. We also saw 15 newcomers join the elite club: APi Group Corporation, Constellation Energy, Energy Transfer LP, Flex Ltd, Liberty Broadband, Eli Lilly & Co, Liberty Media Corp Series C, Nvidia Corp, Progressive Corp, S&P Global Inc, Transdigm Group, Thermo Fisher Scientific, United Therapeutics Corporation, VMware Inc, and Workday Inc.

This VIP basket has outperformed the S&P 500 in 58% of the quarters since 2001, beating the index’s returns by an average of 0.34% per quarter. But here’s the thing: between 2021 and now, the basket’s underperformed the S&P 500 by over 30 percentage points. So it’s not a failsafe, but it does still provide decent insight into where the “smart money” are stashing their cash. And remember, a fresh market cycle could flip that underperformance on its head sometime soon.

Hedge Fund VIP List of 50 stocks that appear most frequently among Hedge Fund top 10 stock holdings. Sources: Solactive, FactSet, data compiled by Goldman Sachs Global Investment Research

What’s the opportunity then?

You have two main options: take it for granted that hedge funds are, ahem, on the money, or use this data to make opposite, contrarian bets. If you’re in the first camp, you could buy the Goldman Sachs Hedge Industry VIP ETF (ticker: GVIP; expense ratio: 0.45%): it tracks the VIP List of 50 stocks, so it would be an easy way to mirror that collection. Or you could pick individual stocks from the list above, and DIY your very own VIP list. If you’d prefer to invest by sector, the iShares S&P 500 Consumer Staples Sector UCITS ETF (IUCS; 0.15%) and Energy Select Sector SPDR Fund (XLE; 0.1%) could come in handy. But if you want to take the contrarian tack, simply short these assets instead via your broker.