Hedge Funds Just Turned Against AI Stocks for the First Time Since 2023. Should You Follow Them?

Last week brought significant losses for those holding AI stocks, with the information technology sector falling 8.2% and the Russell 1000 Growth index dropping 4.8%. Hedge funds were among the biggest sellers, and their actions suggest that regular investors should exercise caution in following the market's lead. According to LPL analyst Michael McClain, hedge funds have become underweight the AI trade for the first time since early 2023, indicating a shift from aggressive buying to risk reduction.

This trend marks the largest sustained period of long/short stock de-risking in over 15 years. Hedge funds sold their existing shares much faster than they opened new short positions, implying that most managers were cutting risk rather than predicting a crash. The phenomenon of crowding further amplified the drop, as AI stocks were widely held by both hedge funds and traditional funds.

When everyone owned the same stocks and decided to reduce exposure simultaneously, prices plummeted, regardless of the underlying companies' performance. However, not all recent rallies are genuine. Some buying has come from hedge funds covering their short positions, buying back stocks they had previously bet against. This can cause prices to surge temporarily but may not last if fundamental investors do not join in.

LPL advises monitoring two key indicators: whether hedge fund exposure continues to decline and if the rally expands beyond the top AI performers. A gradual recovery with broader participation would be more favorable than a rapid return to crowded stocks. While hedge fund selling may indicate reduced risk in the sector, it is not a definitive signal that AI businesses are on the verge of failure.

Investors should remain cautious and consider diversifying their portfolios beyond popular AI stocks to minimize risk.