Investors Can Make a Killing Chasing the ‘Smart Money’

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To profit from the stock market, be sure to follow the “smart money.” Just figure out where hedge funds are investing, and then do the same.

It’s a strategy that would have worked this year if executed properly, as the stocks most widely held by hedge funds have outperformed the broader market.

Luckily for any aspiring smart-money tracker, Goldman Sachs maintains an index of stocks in which fundamentally-driven hedge funds hold large positions — in other words, the companies that matter most to speculative institutional investors.

The Goldman Hedge Fund VIP basket has climbed by about 10% this year, beating the S&P 500 by almost 4 percentage points. Boasting the likes of Facebook, Amazon, Alphabet, and Apple among the most popular and heavily weighted holdings, the index has been a big beneficiary of a stock market that has been rewarding investors for doubling down on proven winners.

Goldman VIP basket

The willingness of hedge funds to continue buying the same strong-performing stocks has pushed the firms’ long exposure to its highest since 2013, according to Goldman. Further, gross leverage — or the total asset value held either long or short by a fund — has surged to its highest since the financial crisis.

Upon first glance, this type of momentum-based investing may seem like a recipe for disaster. After all, crowded positions typically unwind in swift and unforgiving fashion, suggesting considerable downside risk in the event of an unexpected market shock. That’s what happened in early 2016, when high-flying mega-cap tech stocks led to a temporary sell-off.

Not so fast, says Goldman, which points out that high leverage alone has not historically challenged momentum. Rather, there were other external conditions that led to the 2016 weakness that are absent today, most notably earnings.

Mired in a five-quarter profit contraction back then, corporations in the S&P 500 are now coming off their best earnings growth since 2011. Goldman also notes that crowding in hedge funds is less pronounced now than it was a year ago.

Goldman hedge fund crowding