Short selling is booming again after almost being left for dead due to the GameStop mania, reviving hope that hedge funds could turn things around in 2021.
Hedge funds' short book generated in July the best alpha since 2010, and now it's outperforming the long side of their strategies, according to Morgan Stanley prime brokerage data.
The rebound came after a tough start to the year when the monstrous GameStop short squeeze inflicted huge pain for short sellers betting against the brick-and-mortar retailer. As the meme stock trend spread, it caused hedge funds to close out short bets and in general take on less risk.
The outperformance in the bearish bets is good news for hedge funds that are starting to come into favor again after a decade of mediocre performance pushed cost-conscious investors away. After three straight years of outflows, hedge funds saw more than $6 billion client inflows in the first quarter, pushing the industry's total assets under management to a record of $3.8 trillion, according to HFR data.
"Investors are turning to alternative investments for consistent returns to stay in the market after a strong rally to record highs," said Greg Bassuk, CEO of AXS Investments. "Hedge funds also have the component of downside protection against the risks of Covid and the Fed tapering."
The stars appeared to be aligning for a hedge-fund revival. For starters, volatility has made a comeback amid a laundry list of macro risks, from a worsening pandemic to the pullback of monetary stimulus and slowing economic growth.
Meanwhile, stock correlation has fallen to an all-time low from a peak in March 2020, making an ideal environment for stock pickers, according to Bernstein.
"It is easier to pick winners and losers in an environment where stocks are not moving in the same direction in an extreme way," Sarah McCarthy, global quant and equity strategist at Bernstein, said in a note.
Hedge funds have gained 9.2% in 2021 through the end of July, according to HFR. They are still lagging the market significantly, as the S&P 500 climbed 17% during the same period.
— CNBC's Nate Rattner contributed to this story.
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