Hedge Funds Versus Retail Investors: A Dangerous Divergence In Equity Markets

There is a longstanding maxim in investing that it is wisest to follow the actions of ‘smart’ (institutional) money rather than ‘dumb’ (retail) money. This approach has proven effective over time because of the tendency of retail investors to indulge in extremes of either bullish or bearish sentiment which have typically preceded major trend changes in the opposite direction. Therefore, it is worthwhile to watch for divergences in activity between institutional and retail investors.

We are witnessing such a divergence now as the accompanying chart illustrates, with hedge funds reducing equity exposure (and increasing short positions) while retail investors continue to display the type of extreme bullish sentiment that has characterized this bull market.

Beyond the troubling divergence in sentiment between institutional and retail investors, there are a host of other factors that suggest caution should be exercised with equity markets. U.S. stock markets are at all-time valuation highs and inflationary pressures are again building. The potential impact of the deteriorating geopolitical scene has yet to be fully reflected by markets, with a fracturing of the Western Alliance and a looming global trade war likely to have negative implications for global markets.

This confluence of factors is likely to prove our long-held forecast that the 2020s will be noted for its volatility will prove correct. The volatility ahead will be challenging and present significant risks. History also shows that volatile times also produce great investment opportunities as investor sentiment gets stretched to extremes. The years ahead will punish passive investors and richly reward pragmatic investors prepared to seize opportunities across markets and asset classes.

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