Hedge Funds Maintain Big Tech Exposure While Diversifying Portfolios

Hedge funds are maintaining their commitment to Big Tech stocks despite recent market fluctuations. However, after going 'all-in' on the artificial intelligence (AI) theme in the second quarter (April-June), they have begun a significant diversification of their portfolios into healthcare, financials, and energy sectors. This strategic shift has accelerated particularly after the sharp corrections experienced by AI-focused stocks in July.

According to Goldman Sachs' latest Hedge Fund Trend Monitor report, hedge funds entered Q2 with an 'all-in' stance on the AI trade. During this period, portfolio turnover reached its highest level since 2021, with information technology turnover hitting its highest since 2011. Notably, 14 out of the top 20 'Rising Stars'—stocks with the largest increase in hedge fund popularity—were technology companies, underscoring the intense concentration of capital in specific AI plays. However, with the sharp reversal in AI momentum in July, hedge funds experienced their worst monthly underperformance against the S&P 500 index in over two decades.

Following this severe correction, fund managers aggressively cut positions in AI-related semiconductor and mega-cap technology stocks. Despite this reduction, some major tech companies like Amazon (AMZN) and Microsoft (MSFT) remained among hedge funds' most popular holdings, even seeing net accumulation in Q2. This indicates that while funds are moving away from overcrowded AI positions, they are largely maintaining their overall confidence in the technology sector.

In terms of market impact, this diversification strategy has led to notable movements across different sectors. Healthcare has emerged as the largest net exposure sector for hedge funds, accounting for 19% of total net exposure and nearing decade highs. Biotechnology was the most-added subsector. The financial sector's net overweight reached its highest level since before the 2008 global financial crisis, while the energy sector also saw its highest net overweight since 2015. This rotation illustrates how the volatility in the AI trade is reshaping the positioning dynamics of Wall Street hedge funds.

Within a broader economic context, the violent swings in the AI trade have had a direct impact on the overall performance of hedge funds. The year-to-date excess return of the Goldman Sachs VIP basket (an index tracking hedge funds' most popular long positions) has a correlation coefficient of 0.9 with Goldman's AI basket, indicating that any turbulence in AI directly transmits to funds' overall returns. Despite the pullback in July, both gross leverage and AI exposure, which were elevated in Q2, remain above long-term averages.

Analysts and market expectations view this deleveraging and rotation as marking the end of the 'all-in AI' positioning unwind. Goldman Sachs suggests that this rebalancing signals the unwinding of excessively crowded AI positions. US equity long/short hedge funds still posted a 10% return through mid-August, despite the July setback. However, gross and net leverage, as well as AI exposure, while having declined from their Q2 peaks, continue to remain above longer-term averages, suggesting that managers have not completely abandoned risk-taking.