Quant hedge funds suffer worst drawdown since 2023 on momentum failure

Quantitative hedge funds posted their worst performance since December 2023 last week, with systematic long/short strategies falling 3.1% over five trading days as a violent style rotation shattered momentum trades and forced broad deleveraging across technology stocks.

"The selling has been concentrated in the most crowded longs, which is the classic signature of a momentum unwind rather than a fundamental reassessment," Goldman Sachs prime brokerage analysts said in a note to clients.

The drawdown pushed systematic long/short funds down 2.1% in the week through Thursday alone, with the prior five sessions delivering a combined 3.1% decline — the worst such stretch since December 2023, according to Goldman Sachs prime brokerage data. Technology stocks bore the brunt of the selling, with semiconductors ranking as the most net-sold US industry subsector over the past four weeks. The Philadelphia Stock Exchange Semiconductor Index fell 6.3% in a single session and 5.4% the next, though the broader market ended the week higher as money rotated toward other AI beneficiaries.

The episode shows the fragility of crowded trades in a market where a single theme — artificial intelligence — accounts for an outsized share of hedge fund exposure. Even after four weeks of selling, net exposure to semiconductors sits at the 98th percentile of the past five years, leaving managers vulnerable to further unwinding if the rotation deepens. The next test comes as second-quarter earnings season begins, with major tech names set to report in the coming weeks.

Semiconductor Selling Masks a Rotation, Not an Exit

The selling has consisted mostly of managers trimming existing long positions rather than opening fresh bearish bets, the classic signature of profit-taking after a sustained rally, according to Goldman Sachs. Hedge funds' net exposure to semiconductors remains near the top of its historical range even after the four-week selloff, suggesting the trade remains crowded rather than abandoned.

Goldman's analysts said they do not view the selling as a regime shift away from the AI theme. Hedge fund positioning in US AI stocks broadly remains at historically elevated levels. The chips are being pruned; the thesis behind owning them is not being abandoned, they said.

The backdrop helps explain the caution. Higher inflation readings and climbing bond yields have pushed managers to add downside protection across their books, and the most obvious place to take profits is the sector that has run the hardest. The 10-year US Treasury yield has climbed 15 basis points over the past two weeks as stronger-than-expected economic data reduced expectations for near-term rate cuts, compounding the pressure on high-growth tech stocks.

Bond Yields Add Pressure to Crowded Tech Trades

The last time systematic funds suffered a comparable drawdown was in December 2023, when a sharp reversal in mega-cap tech stocks triggered a 3.5% decline in systematic long/short strategies over a similar timeframe, according to Goldman Sachs data. That episode preceded a 10% rally in the S&P 500 over the following two months as the Federal Reserve signaled the end of its tightening cycle.

The rotation is worth watching in its own right. As the most obvious chip names have grown expensive, some managers have started hunting for the next tier of companies expected to benefit from AI spending, from power and cooling suppliers to the software layer sitting on top of the hardware. Money leaving semiconductors is not the same as money leaving the trade; often it is just moving one step along the chain.

The concentration is the nagging worry underneath it all. When a single theme accounts for so much of a portfolio and a handful of names carry the index, even orderly profit-taking can turn disorderly if enough funds decide to trim at once. Goldman's data suggests that is not happening yet, but the same figures that show discipline also show how much is riding on the trade staying intact.

Whether this is a pause or the start of something larger is the question the data cannot yet answer. For now, the funds are trimming a winner, not walking away from it.

This article is for informational purposes only and does not constitute investment advice.