Disparity in US stock performances gives hedge funds edge to cherry-pick and boost returns: Morgan Stanley

In 2024, much of the gains in S&P 500 have been driven by select sectors like technology, media and telecom.

There has been a visible disparity in stock performances for different sectors in the US equity market in 2024, creating an ideal environment for hedge funds to cherry-pick winners and generate greater alphas, global brokerage Morgan Stanley believes.

The brokerage drew parallels between the US market's performance in 2023 versus that in 2024 and highlighted that while sector contributions to the S&P 500's gains were relatively balanced in 2023, it has seen greater disparity in 2024. Telecom, media, and technology sectors have driven most of the index's returns this year. The brokerage also noted that while the macro-driven environment of 2022 and 2023 saw assets reacting mainly to inflation, interest rates, and other macroeconomic factors, 2024 has seen the market shift more towards micro fundamentals.

Along with this, Morgan Stanley highlighted that its internally maintained S&P 500 risk-on/risk-off model, which measures shared risk and market-wide co-movements, has declined this year, further suggesting that macroeconomic factors are weighing less on equity markets.

This trend has also coincided with an uptick in stock-specific risk, hinting that fundamentals are increasingly influencing stock prices. Accordingly, Morgan Stanley believes that these dynamics are a direct result of the higher interest rate environment, which has resulted in increased opportunities for alpha production conducive to hedge fund strategies seeking to deliver skill-based returns to investors.

"These environments have led to an outsized performance by long/short equity market-neutral hedge funds which are reliant on stock picking to generate their returns," Morgan Stanley wrote. On the contrary, the brokerage also highlighted that the same environment has not been beneficial for alpha production by long-only equity managers, noting that these funds are likely to underperform index-level returns if they don't own the select stocks that drove much of the gains in 2024.

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Morgan Stanley further charts out two other reasons that uniquely position hedge funds to deliver better returns in the current scenarios--their ability to generate both long and short alpha and their unconstrained approach versus traditional benchmarks.

Against this backdrop, Morgan Stanley believes the environment will continue to offer abundant alpha opportunities for hedge funds. "Even though the Federal Reserve is likely to start cutting interest rates, we expect base rates to remain historically high, which should sustain market dispersion and stock-picking prospects," the brokerage stated.

"Additionally, upcoming elections and the potential for shifts in US leadership could create further opportunities for selecting individual stocks based on policy impacts. We remain confident that hedge funds will make the most of these ongoing opportunities and that incorporating market-neutral strategies could benefit a well-balanced portfolio," it added.

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