Who's right? Individuals bearish,hedge managers are bullish

11/30/2009 1:33 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Individual investors say stocks are going to fall. They’ve pulled $3.7 billion out of equity mutual funds since August, according to the Investment Company Institute.

Hedge fund managers say they’re going up. They’ve got more money in stocks than at any time since the end of 2007. Managers increased their stock holdings by 21% in the third quarter, according to Goldman Sachs.

Who’s right?

History says the odds favor the professionals. Though hedge funds aren’t infallible by any means—900 went out of business in 2008—they do have a better record than individuals at catching rallies after a big decline.

There’s considerable debate about why.

One theory holds that individuals have longer memories: Still vividly remembering their losses in the last market collapse, they tend to stay on the sidelines long after rallies have lifted stocks off a bottom, the data says. This year for example, as of the end of October, individuals have taken a net $21.4 billion out of equity mutual funds, according to Morningstar.

Another theory says that hedge funds look like they hop back into rallies faster than they actually do because managers hedge their purchases of shares by selling short or buying put options that will go up in price if stock prices decline. There’s evidence of that in the recent data: While hedge funds held $604 billion in stocks at the end of the third quarter of 2009, they had also increased their short positions—bets that stocks will go down—to $363 billion in the quarter.

Shares of stock sold short on the New York Stock Exchange climbed to 3.5% of all shares outstanding at the end of October. That’s 40% above the average for this decade, according to Bloomberg.

If you include those short positions, professional hedge fund managers are still more bullish than individual investors. But clearly they are hedging their bets.

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