Summary: Hedge funds (HFs) experienced limited benefits from the market's grind higher, as short positions generally outperformed long positions over the week. As a result, average HF returns remain at +1.1% month-to-date (MTD), even though the MSCI AC World index is up 3%. Equity Long/Short (L/S) funds globally are holding at +1.3%, while Equity Quant funds are slightly down MTD on a market-neutral basis (-0.3%).

From a flow perspective, US gross flows were relatively flat, with gross leverage unchanged across HFs, maintaining all strategies’ gross leverage at all-time highs (ATHs). HFs were small net sellers both in the US and globally, leading to a 2% decline in net leverage across all strategies, although net leverage for Equity L/S funds remained flat. Positive flow dynamics such as ETFs and cyclical/defensive flows supported weekly and monthly changes in Tactical Positioning Monitor, which ticked up to +0.5z (76th percentile).

Regarding the rally in shorts, High Short Interest (SI) stocks (JPTASHTE Index) have started to show accelerated outperformance, missing during the rebound from mid-April to mid-July. Over the past 10 days, High SI stocks outperformed the S&P 500 (SPX) by nearly 10%. Despite recent performance challenges, there is little evidence of accelerated short covering or Quant de-grossing to suggest the rally in shorts will end quickly. If retail investors maintain bullish option flows, HFs may face pressure to cover shorts faster, potentially curtailing their outperformance.

Small caps have also been outperforming, with the Russell 2000 reaching a new ATH. If gains persist, further increases in small-cap positioning could drive the index higher, supported by:

- Asset managers showing limited long exposure (based on CFTC data).

- Potential CTA positioning increases.

- A rebound in small-cap ETF flows from multi-year lows.

- HF positioning favoring large caps over small caps.

Outside the US, EMEA markets saw small net selling, driven by reduced long positions. APAC buying was led by Japan, while profit-taking occurred in Chinese ADRs. European indices remained rangebound, with HFs adopting a tactical approach. Notably, EU Semiconductors and Luxury Goods experienced selling into rallies and light positioning. If gains persist, HFs may adjust positions higher, as seen in past trend reversals.

Sector Highlights:

- North America: Buying was led by ETFs and Communication Services (Media & Entertainment). Homebuilders saw short covering but remain net sold over the past two months with low positioning. Cyclicals and Tech (Semis and Software) were sold despite the recent rally in Semis. Banks were sold (-1z) despite their rally last week.

- Europe: HFs bought Industrials (Capital Goods), Financials, and Staples, while selling Real Estate, Healthcare, and other cyclicals such as Materials, Energy, and Consumer Discretionary.

- Asia: AxJ Tech (Semis and Tech Hardware) saw strong buying amid performance rallies, while most other sectors were sold. In Japan, buying was broad-based, led by Energy, Tech, and Defensive sectors.