Hedge Funds Suffer Historic July Underperformance as AI Trade Unwinds

Hedge funds entered the third quarter heavily exposed to artificial intelligence after AI stocks powered strong returns earlier in the year. According to Goldman Sachs, its Hedge Fund VIP basket of the most popular long positions subsequently suffered its largest one-month underperformance versus the S&P 500 in more than two decades of data.

The reversal coincided with a sharp reduction in hedge fund positions during July. Funds trimmed holdings across several AI-related areas, particularly semiconductor stocks and many mega-cap technology companies, as momentum in one of the market’s most crowded trades weakened.

The shift represents a significant change from the second quarter, when hedge funds were effectively “all in on AI.” Portfolio turnover reached its highest level since 2021, while strong performance from popular AI stocks pushed hedge fund crowding to a record.

Technology dominated the stocks attracting additional hedge fund interest during that period. Goldman found that 14 of the 20 “Rising Stars” — stocks recording the largest increases in hedge fund popularity — came from the technology sector.

That concentration proved painful when AI-related stocks began to reverse. Goldman said hedge fund performance, leverage and popular long positions have moved increasingly in tandem with the AI trade over recent months, highlighting how concentrated exposure can amplify both gains and losses.

Funds have since started diversifying away from AI. Gross leverage, net leverage and overall AI exposure have all declined from their second-quarter peaks as managers reduced risk and repositioned portfolios.

However, the retreat should not be interpreted as a complete exit from the theme. Goldman noted that hedge fund leverage and AI exposure remain above their longer-term averages, suggesting managers are reducing concentration rather than abandoning artificial intelligence altogether.

Despite July’s historic relative underperformance, hedge fund returns for the year remain positive. U.S. equity long/short funds had gained approximately 10% through mid-August, indicating that the strong first-half performance has so far cushioned the impact of the recent AI sell-off.

The episode highlights the risks created when institutional portfolios become heavily concentrated around the same market narrative. As hedge funds diversify, the next phase of the AI trade may depend less on broad momentum and increasingly on whether individual companies can deliver earnings growth sufficient to justify elevated valuations.