Goldman Sachs flags historic hedge fund pain as AI trade unravels

According to Goldman Sachs, hedge funds suffered significant losses as the AI rally lost momentum in July. The bank said the pullback in AI-related stocks forced managers to unwind some of their heavy positions, resulting in one of the strongest de-grossing periods of the past 10 years. 

It noted, “Our Hedge Fund VIP list of the most popular long positions suffered its worst 1-month underperformance vs. the S&P 500 in more than 20 years of history, and July marked one of the sharpest hedge fund de-grossing episodes of the past decade.”

At the moment, hedge funds are pulling back fast from AI stocks, according to the bank.

Hedge funds lost over 3% of their profits in July

Data from across Wall Street also support this cooling-off period.

Similarly, JPMorgan in early August contended that tech sell-offs wiped out 3% of hedge fund gains in July.

According to their analysts, fund managers got trapped in overcrowded tech positions, creating a bottleneck that prevented speculators from cashing out before their profits vanished.

However, this summer slump might actually be part of a predictable seasonal pattern. JPMorgan noted that since 2018, hedge funds have tended to dump unprofitable stock positions in July. Because of this cycle, the bank hinted that traders could very well pick up tech stocks again by September, noting that managers frequently drop trades in mid-summer, only to buy back into the market in the coming months.

This year, when AI trade started losing momentum, analysts were still optimistic about AI trade and hedge fund performance. In late July, Vincent Lin, co-head of Prime Insights and Analytics in Global Banking & Markets, even noted that hedge funds were still deeply committed to AI tech.

At the time, he explained that the historic wave of tech selling looked more like a healthy market correction amid high volatility than a decline in confidence in AI. However, with traders currently moving away from AI, it’s unclear whether investors are still bullish on tech stocks.

Earlier this year, the war in Iran triggered a rough March for hedge funds. Though the funds rebounded quickly thanks to a massive chip stock rally led by Samsung, AMD, and SK Hynix. 

The AI boom significantly contributed to the overly positive hedge fund performance in Q2

Primarily, the AI stock frenzy boosted second-quarter hedge fund performance, propelling investor crowding to historic heights. Per Goldman, tech stocks grabbed 14 out of 20 spots among the fastest-growing favorites on Wall Street. 

Overall, according to data provider HFR, strong investment performance helped boost total industry assets by $409 billion, bringing the grand total to $5.6 trillion in the quarter. It also showed that macro strategies, where hedge funds make investment bets tied to indicators such as growth and inflation, took the crown as the most sought-after hedge fund style this year.

Speaking on the great performance back then, Shenan Dhanani, co-chief executive at Trium Capital, noted that this could be a “golden era” for the funds. 

However, hedge fund performance has since slipped from those highs, though the funds are still outpacing their usual averages.

The concentration of hedge fund portfolios in AI-linked companies also made the July reversal more painful. Stocks connected to semiconductors, cloud computing, and AI infrastructure had attracted significant institutional demand during the rally, leaving many managers exposed to the same group of trades.

When momentum weakened, crowded positioning amplified losses as investors rushed to reduce their exposure simultaneously. This suggests that the July sell-off was not necessarily a rejection of artificial intelligence as an investment theme, but rather a warning that valuations and positioning had become stretched.

“Despite the volatility, US equity long/short hedge funds have returned 10% through mid-August,” Goldman said.

If hedge funds return to technology stocks in September, the latest pullback could prove to be little more than a summer repositioning.

However, continued weakness in AI-related shares could force managers to reassess the positions that helped drive their strong gains earlier this year.