AI: beyond the hype

Equity investors' belief in the transformative power of AI has been giving a boost to long/short equity hedge funds

ChatGPT, a chatbot developed by Open AI, captured investor imagination and triggered a phenomenal rally in technology stocks in H1 2023. With Intelligence’s latest hedge fund strategy report, which examined the performance of long/short equity funds in the first half of 2023, showed the strategy has taken a boost from this investor sentiment.Artificial intelligence appeared to be the only game in town for the best part of this year – after an abysmal 2022 for stocks, dragged down by inflation at 20-year highs and unprecedented interest rate increases by the US Federal Reserve and its counterparts, investors piled into technology stocks they thought would benefit most from the spread of AI.

Investors are betting that ChatGPT has ushered in an artificial intelligence era that will lead to a leap in human productivity and transform business and everyday life. Generative AI, the technology ChatGPT is based on, uses large language models to understand and produce human-sounding language to answer questions and assist in composing emails, essays, articles, and code.

“Generative AI will change the way companies use data and any company that does not use generative AI for better insight into their business will be left behind,” Javier Panizo, global consumer analyst and portfolio manager at Nomura Asset Management in London, told With Intelligence. “Generative AI will be a game changer for consumers as well. Generative AI will make enterprises and consumers more productive and will enhance the productivity of the global economy.”

Investors have been buying in to the promise of continued future revenue growth at companies that are in the forefront of AI adoption.

Hedge funds were as eager as investors to jump on the AI bandwagon.

Gains posted by the largest US technology stocks based on optimism that AI applications would boost earnings also helped long/short equity hedge funds, which manage $1.1tn in total, to do better than other strategies in the first half, the With Intelligence Long/Short Equity Hedge Fund Strategy report showed.

The Magnificent Seven

The winners of this year’s AI-propelled equity-market boom – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – have been referred to as the Magnificent Seven, inspired by the 1960s Western movie. And hedge funds investing in these seven biggest US technology companies on the expectation that they will benefit from their push into AI have been instrumental to the US equity market gains this year.

The shares of these seven companies, which all posted deeply negative returns last year, rose more than 90% on average in the first half of the year, helping the S&P500 post a 16% gain and the tech-laden Nasdaq Composite to soar by nearly 32%, its best first-half performance in 40 years.

The best performer among them was Nvidia, with its stock price rising 190% over the period on expected demand for its chips used to train generative AI software like ChatGPT. As the mega-cap tech companies have all entered the AI race, expectations that they will also be big customers of Nvidia contributed to gains in its share price.

Santa Clara, California-based maker of graphics processing units (GPUs) Nvidia reported revenue of $13.51 billion for the three months ended on July 30, more than doubling from $6.7 billion in the same quarter a year earlier. Its diluted earnings per share rose to $2.48 from $0.26 a year earlier.

“A new computing era has begun,” said Nvidia founder and chief executive Jensen Huang in an earnings statement. “Companies worldwide are transitioning from general-purpose to accelerated computing and generative AI. Nvidia GPUs… make up the computing infrastructure of generative AI,” adding that, “The race is on to adopt generative AI.”

The company that is probably taking the biggest bet on AI is Microsoft. It partnered with OpenAI, the company behind ChatGPT years ago and this year it increased its stake. Its investments have reportedly totalled $13 billion it now owns 49% in the AI pioneer. It also moved fast to integrate AI chatbots it calls ‘copilots’ into all its products, from its Bing search engine and Microsoft 365 productivity software to its Azure cloud services platform.

Each of the Magnificent Seven is seeking to benefit from AI technology in its own way.

Alphabet, which dominates internet search with Google, launched its own AI chatbot Bard earlier this year, and it’s planning to integrate it into its search engine. Amazon, the leader in cloud services with its Amazon Web Services unit, said it will invest up to $4bn in cash in AI startup Anthropic, to respond to challenges from in cloud computing from Microsoft and Alphabet. Apple is testing AI applications for Siri, its virtual assistant, and Meta, Facebook’s parent, wants to embed AI in its social networks.

Panizo of Nomura sees Nvidia, Microsoft and Alphabet as the main long-term beneficiaries from generative AI.

“These three companies will be able to monetize generative AI the best in our opinion,” Panizo said. “Nvidia is selling AI chips that provide the infrastructure for generative AI. Microsoft is infusing generative AI capabilities called Copilot into applications like Office, as well as allowing their Azure customers to combine their proprietary data with ChatGPT for business analytics.” He added that the investment case for Alphabet was “better engagement with search results by embedding Bard with their traditional search, which will lead to higher ad prices.”

Hedge funds hold record exposure to the seven biggest tech stocks by market capitalization, according to Goldman Sachs analysis. These seven stocks collectively made up some 20% of the total net market value held by hedge funds.

AI: powering performance?

Long/short equity was the leading hedge fund strategy over the first half (5%) with its best performance since H1 2021 amid a rally in US stocks, driven by accelerated AI adoption and prospective productivity gains, and stronger than expected US economic performance, our report shows.

Long/short equity funds account for about a third of all assets invested with hedge funds.

Taking long positions in shares that they believe to be underpriced and short selling the ones that appear to be overvalued worked to managers’ advantage in H1 2023. Long/short equity funds posted a 5% return in the first half of this year, rebounding from an annual loss last year, when they finished at the bottom of the strategy return table. Their H1 returns beat the 3.9% posted by multi-strategy funds and the 1.9% return achieved by following a distressed debt strategy, according to the report, which was compiled from performance data With Intelligence collected from hedge funds.

Within long/short equities, tech-focused hedge funds were the biggest winners in the first six months of 2023, returning 10.1%, probably further testament to the positive contribution from the gains by technology shares on the back of the AI enthusiasm.

AI hedge fund strategy return map 2018-2022

Even so, both the performance of the long/short equity funds and the tech funds fell short of the nearly 16% increase by the S&P 500 and the almost 37% gain by the tech-heavy Nasdaq Composite in the first half of 2023.

Alpha, the main goal of every fund manager – outperforming the benchmark for performance they have set on a risk-adjusted basis – has become “increasingly difficult to generate” with long/short equity strategy, given some extremely strong ‘bull runs’ by equity markets in the past five years, the With Intelligence report notes.

This has held even truer for tech funds, as many of those ‘bull runs’ have been led by technology shares. With Intelligence data analyzed in the report showed that tech-focused funds in 2023, on average, have found it “harder since 2020 to capture some of the outsized upsides of tech stocks, particularly during this year’s rally.”

AI comparative statistics table

Tech-stocks: safe haven?

Long/short equity funds in general, and the ones focused on tech stocks in particular, have held up reasonably well during recent equity market selloffs.

In 2022 when stock markets were rattled by accelerating inflation and the start of an unprecedented tightening campaign by central banks, long/short equity funds posted a loss of 94% However, this still ranked as their biggest outperformance compared with stocks since the 2008 financial crisis. World stocks fell as well as large-cap cap US stocks, which tumbled more than 19% in 2022.

With Intelligence data shows long/short equity hedge funds focused on the tech sector have provided better protection than the long/short equity average during recent equity sell-offs – such as the stock routs that occurred during the early part of the Covid pandemic, the invasion of Ukraine, and last year’s runaway inflation, bringing the beginning of steep interest-rate hikes.

AI hedge fund strategy return map 2018-2022

The better relative performance – more limited negative returns – can possibly be put down to the fact that the tech-focused hedge funds are more heavily invested in ‘growth’ stocks and large-cap technology, media and telecom stocks, the likes of Apple, Amazon, Alphabet, Microsoft and Meta, which have acted as a safe haven in tough times for equities, according to the report.

Is AI fever ending?

Given the dizzying speed of the share price gains this year by the big-cap tech companies, some speculate that this is just another bubble, akin to the dot-com boom.

Goldman Sachs strategists believe that even as the largest technology stocks have rallied substantially, it doesn’t appear to be a bubble, according to its report, ‘Why AI stocks aren’t in a bubble’: “We believe we are still in the relatively early stages of a new technology cycle that is likely to lead to further outperformance,” says Goldman Sachs chief global equity strategist Peter Oppenheimer in the Goldman report.

The valuations of the stocks leading the market are not as stretched as in previous periods, such as the internet bubble that collapsed in 2000, and tech companies have unusually strong balance sheets and returns on investment, he says. The seven biggest US companies seen as leaders in the race to commercialize generative AI technology have an average price to earnings ratio (P/E) of 25. That compares with a P/E of 52 for the biggest companies at the peak of the internet bubble.

As world leaders debate the future of AI at the AI Safety Summit in Bletchley Park, UK, this November, one question on everybody’s lips is to what extent the valuations reached by the largest technology stocks this year are justified by the promise of AI-driven future revenue growth.

The rise of technology shares stalled in the third quarter of 2022. Four of the Magnificent Seven stocks declined, and the tech sector was one of the weakest segments of the market. It remains to be seen whether this was a correction, or the AI-adoption story has run out of steam as doubts about the technology surface, underscoring the bubble theory.

The US economy stayed quite resilient in the face of the Fed’s unprecedented interest rate increases, allowing the stock rally. Market participants began to expect the Fed to end begin to lower rates.

Instead, it’s become obvious that policymakers are relentless in their fight against inflation. While the inflation rate is coming down, rate setters indicated that the strength in the economy merits higher interest rates for longer. The Fed being more hawkish than anticipated has pushed bond yields higher.

Giorgio Vintani, a partner and equity strategist at Inflection Point, a website for investors, said that the third-quarter correction in technology shares can be blamed on the surge in bond yields rather than valuations.

“In terms of valuations, the Magnificent Seven are relatively cheap, but there are very strong headwinds on the rate side,” Vintani told With Intelligence. “And now, there is a real alternative. If I can get nearly 5% in US dollars on Treasuries, why should I put my neck out and invest in Apple, or Nvidia, or any of the Magnificent Seven, especially if I am a risk-averse personal investor?”

Vintani believes the AI-fuelled rally “has everything in place” to continue, provided that rates eventually find a ceiling.

With Intelligence will continue to track the extent of tech stocks’ influence on long/short equity hedge funds with new sector-specific data from our analyst team, drilling down into the best performing sectors within long/short equities.


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