Hedge funds have jacked up their bets on the stock market to their highest levels of 2016 and cut back on short positions to a three-year low amid a blistering post-election rally.
For the fourth quarter, the $3 trillion industry increased its net exposure — the difference between short and long positions — to 63 percent, a level that equates to a net $656 billion, according to Bank of America Merrill Lynch data. Hedge funds were last this optimistic in the fourth quarter of 2015.
Managers have been rewarded for their optimism. The is up 4.4 percent for the quarter, while the Dow Jones industrial average has surged 8.9 percent and is threatening to eclipse 20,000 for the first time.
Interestingly, the industry misjudged somewhat where the biggest gains would come. Hedge funds cut their exposure to small-cap stocks to the lowest level since the second quarter of 2014, at a time when the has jumped 9.6 percent.
Otherwise, though, hedge funds made some smart bets, according to BofAML's tracking.
The industry cut its net short position in exchange-traded funds to $65 billion from $72 billion at the start of the quarter, the lowest since the third quarter of 2013.
During the third quarter, ETF buying focused most on the SPDR S&P 500 Trust, the iShares MSCI Emerging Markets and Financial Select Sector SPDR funds. Those funds, respectively, have seen fourth-quarter returns of 4.6 percent, -8.1 percent and 22.3 percent.
Conversely, the three most-sold ETFs were the iShares iBoxx $ High Yield Corporate Bond ETF (down 0.8 percent for the quarter), the SPDR Gold Trust (off 13.6 percent) and the iShares Russell 2000 ETF, the worst move as the fund has jumped 10.1 percent.
As a group, hedge funds in November rose 0.9 percent, posting their best month since July, as gauged by the HFRI Fund Weighted Composite Index. The index was up 4.5 percent for the year heading into December.
The enthusiasm hedge fund managers are showing is not universally shared.
As a group, Wall Street strategists are expecting the S&P 500 to gain just 4.2 percent in 2017. That's the most pessimistic outlook since 2005, according to Bespoke Investment Group.
However, that could change as the year ahead evolves. Citigroup, for instance, already has revised its 2017 outlook, upping its S&P 500 price target from 2,325 to 2,425, representing about a 7.2 percent gain from the current level.
Retail investors remain bullish. Some 44.6 percent expect the market to be higher in six months, according to the latest American Association of Individual Investors survey. That's above the historical average of 38.5 percent.