Hedge fund returns outpaced the stock market in October, but were still negative, according to a Morgan Stanley Prime Brokerage report. With stocks looking to break nine straight days of losses on Friday, the report reveals hedge funds were largely involved in starting the short parade. The S&P 500 gave up a slight -1.94% in October as hedging the upcoming Presidential election and potential interest rate volatility are the general fundamental reasons attributed to the near 3% selloff that occurred over the last nine days.

Also see Q3 2016 Hedge Fund Letters

Short exposure helps Long/Short hedge funds, while Event Driven Funds in Americas doing well

October marks the first month in five that hedge funds were net sellers of equities, the Morgan Stanley report noted. Hedge funds in the brokerage study were overall down -0.52% in October and are now up 1.71% year to date. By contrast, the S&P 500 is up 4.02% year to date.

Long/Short strategies were down -0.41% and generally featured high net short leverage, with the small-cap sell-off particularly benefiting short alpha. Additionally, in a sign which might worry some the brokerage notes that gross leverage for long short American-based hedge funds has hit the highest levels since 2008. However, for net leverage the level is quite low, as is the gross ratio for non US L/S funds.

In North America, the long side underperformed but short exposure had its best showing since May. European and Asian hedge funds did not benefit to the same degree from their short exposure. In Europe, cyclicals have been significantly outperforming defensive stocks since September, but hedge funds now appear to be fading this move. European hedge fund long exposure, however, performed in line with the MSCI Europe index on the month.

While most hedge fund strategies were off on the month, Americas event-driven funds were the rare exception, up 0.31% on average. For the year the average Americas event-driven fund was up 3.24%, with Americas Equity Long/Short funds up 3.86%, leading all hedge funds in the survey.

On the year most hedge funds are positive, with a few exceptions. European hedge funds had the worst performance in October, down -1.08%, while Asian Equity Long/Short funds followed closely at -1.26%. Asian hedge fund long exposure was hampered by tech stocks, the largest sector in the region as short exposure was also troubling.

Energy longs are winning trades for many hedge fund, but health care stocks, after a sprint higher, give up gains

Looking at sector, hedge fund energy longs remain the best performing stocks year to date despite witnessing a 5% drop in August.

Financial stocks were the best performing MSCI sector but hedge fund financials lagged, the report noted. For Long/Short strategies, Telecom was the best spread performer.

Health care longs were problematic once again, as an eye on political pressure continues to weigh on performance. After having gained close to 4% in both August and September, they gave up all their gains and then some in October, down -9% on the month. Gains on shorts in healthcare were unable to offset the big losses on longs.The losses in healthcare this October can only remind us of a similar period last year when Valeant and Shkreli led the entire sector to a massive decline.

Looking at factor analysis, stock selection were key considerations as the small cap Russell 2000 significantly underperformed the S&P 500, impacting performance. Throughout much of the year, short exposure in the Long / Short book was more of a positive contributor than long performance until after the Brexit vote, but recently short exposure has gained in importance and is now near long in terms of style factor portfolio impact.

In regards to leverage, European-focused Equity Long / Short funds saw net leverage increase by 3% in October, while gross increased 4%.  European net leverage is at the 56^thpercentile since January 2010 as the gross leverage is even more elevated, near the 93rd percentile over the same period.