Hedge Funds Suffer Worst AI-Driven Reversal In 20 Years As Investors Cut Crowded Tech...

Hedge funds suffered their sharpest one-month setback against the broader U.S. stock market in more than two decades in July as investors reduced crowded positions in artificial intelligence stocks, marking one of the most significant reversals of the AI trade in recent years, according to Goldman Sachs.

Goldman Sachs strategists led by Ben Snider said the bank's Hedge Fund VIP basket, which tracks the stocks most widely held as long positions by hedge funds, recorded its worst one-month underperformance against the S&P 500 in more than 20 years of history.

July also produced one of the sharpest episodes of hedge-fund "de-grossing" in the past decade, as funds reduced both long positions and overall exposure to equities.

"Funds trimmed positions in a number of AI stocks, including many semiconductors and most of the mega-caps," the Goldman strategists said.

The retreat represents a significant shift from the second quarter, when hedge funds increased exposure to the stocks driving the AI rally and generated strong returns as technology companies led the broader market higher.

Goldman said hedge funds entered the latest quarter effectively "all in on AI", with portfolio turnover reaching its highest level since 2021. The concentration subsequently began to unwind as investors reassessed crowded technology positions and reduced exposure to some of the market's biggest AI beneficiaries.

"Hedge fund performance, leverage, and the most popular long positions have swung sharply with the AI trade during the last few months," Goldman said.

The reversal underlines the risk created by the concentration of hedge-fund portfolios around a relatively narrow group of AI-related stocks. As semiconductor companies and mega-cap technology firms became increasingly popular, their performance had an outsized influence on hedge-fund returns.

Goldman said hedge-fund crowding reached a record during the second quarter as the market was driven by popular AI stocks. Technology companies dominated the list of so-called "Rising Stars", with 14 of the 20 stocks that recorded the largest increases in hedge-fund popularity coming from the technology sector.

That positioning worked in hedge funds' favor while the AI trade was advancing. When momentum weakened, however, the same concentration amplified the downside.

The July sell-off prompted funds to reduce exposure, a process known as de-grossing. Gross leverage measures a fund's total long and short exposure, while net leverage measures the difference between those positions. A decline in both indicates that managers were reducing the overall amount of risk in their portfolios rather than simply rotating from one group of stocks to another.

Goldman said hedge-fund gross leverage, net leverage and AI exposure have all declined from their second-quarter highs. However, all three remain above their longer-term averages. That suggests the July adjustment has not amounted to a wholesale abandonment of AI or technology stocks. Rather, hedge funds appear to be reducing the degree of concentration and leverage around the trade after a period in which positioning had become unusually aggressive.

The AI investment cycle remains a major driver of corporate spending, semiconductor demand and technology-sector earnings. The retreat by hedge funds therefore does not necessarily signal that investors have abandoned the long-term AI growth thesis. Instead, it points to growing sensitivity around valuations, crowded positioning and the ability of companies to generate returns from the enormous sums being committed to AI infrastructure.

The performance data also show that hedge funds have so far been able to absorb the volatility. U.S. equity long/short hedge funds were up about 10% through mid-August, according to Goldman.

That gain leaves funds ahead of many traditional investment strategies even after the sharp reversal in July. It also suggests that managers have been able to offset losses in crowded AI positions through short positions, diversification and exposure to other parts of the market.

The latest shift comes at a critical point for technology investors. AI-related companies have driven a substantial portion of the market's gains, while the semiconductor industry has attracted heavy institutional investment because of expectations for continued demand from data centers and AI accelerators.

But the concentration of capital has also increased the potential for abrupt market moves when investors reassess growth expectations. A simultaneous reduction in positions by highly leveraged funds can accelerate declines in crowded stocks, particularly when liquidity is thin.

Goldman's assessment therefore points to a broader change in market behavior. The AI trade remains important to hedge-fund portfolios, but managers are becoming less willing to maintain the extreme concentration and leverage that characterized the earlier phase of the rally.