Hedge Funds Are Still Buying Stocks. What That Means for the Market.

Hedge funds’ stock-market exposure is near a high for this year.

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Hedge funds have been betting on continued gains in stocks. But at some point, they may not want to plow so much money into the market.

In its latest investor survey, Evercore ISI found that hedge funds’ exposure to stocks is near the highest it has been all year. The gauge climbed to 52.3 as of Dec. 23, according to a recent note from the firm. That compares with a reading of 51.4 on Dec. 9, and this year’s low of 48 from March. In other words, hedge funds have only been this heavily invested in the stock market about 25% of the time since 2010, Evercore found.

Part of what has fueled the run-up in stocks is investors redeploying cash after the pandemic panic. The S&P 500 is up more than 65% from its March 23 low.

“Hedge funds’ increased exposure to equities presumably comes at the expense of other asset classes, like cash,” wrote Dennis DeBusschere, head of portfolio strategy research at Evercore, in a recent note.

Large institutional funds—hedge funds and other professional investors who manage pensions’ and companies’ money—raced into cash in March and then drew on that cash to buy stocks in the second half of the year. Institutional investors’ cash holdings rose 43% between Feb. 17 and May 25, to $3.27 trillion, according to data from the St. Louis Fed.

More importantly, institutional funds’ cash holdings have now declined. As stocks rallied, cash holdings plummeted 21% to $2.85 trillion by December.

Large money managers now have about 4% of their portfolios in cash, on average, which strategists at Bank of America said in a recent note is a sell signal. That is because, with less cash on hand, investors are less willing to take risk—especially with the stock market trading at higher valuations after its rebound. Institutional funds were holding almost 6% in cash in March, when risk aversion was at its peak.

That could imply that investors are nearing their desired exposure to the stock market. This could hurt demand for stocks, especially as valuations are arguably fair, not cheap.

Some have been looking for a near-term pullback, and there was a pause in the S&P 500 between Dec. 4 and Dec. 23. Even so, “people were expecting a bigger pullback,” Marc Pfeffer, chief investment officer at CLS Investments, told Barron’s.

He mentioned that with long-term Treasury yields still below the expected rate of inflation, stocks are “the only game in town,” so he wouldn’t be surprised by more near-term gains.

But the next meaningful leg higher in stocks may be dependent on stronger economic growth and higher earnings estimates. So don’t expect funds to be as aggressive as they were this year.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com