Last week we discussed why even as the stock market ramped to new all time highs, hedge funds found themselves badly underperforming the S&P, and are now not only more than 5% below their January highs, but remain red for the year near the worst levels for 2018.

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What are the reasons for this stark underperformance? It appears there are two main catalysts.

First, as BofA wrote last week, many hedge funds had simply not allocated enough capital to the market's lone group of massive outperformers, the FAANGs. The bifurcated returns were on full show in August, when the S&P 500 rose 3%, yet when Apple shares surged 20% while the rest of the FAANGs, Facebook, Amazon, Netflix and Google, climbed 6 percent. Without those five stocks, Bloomberg calculates that the S&P 500’s August gain would have been cut nearly in half to 1.8%.

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Second, and more important, hedge funds appear to have lost their way in 2018. Recall that as Goldman wrote in its observations of 2Q 13F that arguably the biggest contributor to underwhelming hedge fund performance has been declining hedge fund net exposure. Net long exposure calculated based on 13-F filings and publicly-available short interest data registered 55% at the start of 3Q, slightly lower than in 2Q. Worse, data from Goldman's Prime Services division showed that net leverage had been declining steadily during recent months while the S&P 500 recovered to within 1% of its record high. In other words, as stocks ramp, hedge funds were rapidly delevering, uncertain about the future trajectory of the S&P.

Now, according to some new analysts from Morgan Stanley, the smart money has only been getting more cautious, despite having already been stung by a defensive stance on U.S. stocks.

According to Bloomberg, hedge funds’ net leverage, has continued to shrink and has fallen to the lowest level this year after a brief bounce in late August, and at 49% the ratio is down from a peak of more than 60% in March.

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The growing reluctance of the "trapped" smart money to increase equity exposure demonstrates the growing skepticism about the durability of the S&P 500 against stocks markets in the rest of the world, a divergence which recently hit all time highs.

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This lack of conviction in U.S. stocks may have been the main reason hedge fund managers had to watch in pain while the market rallied in July and August. During that stretch, Bloomberg notes that those with a focus on equities saw their underperformance versus the S&P 500 widen by 5%.

The poor returns also prompted Nomura to predict that the industry will have to sharply increase leverage. And yet, despite the S&P trading less than 1% below its all-time highs, so far hedge funds have failed to muster the courage to do what they need to avoid a flood of redemptions at the end of the year, afraid that it is only a matter of time before the "alligator jaws" shown in the chart above, and highlighted by Jeff Gundlach in his latest Double Line investor call, will snap shut, costing those who chase the rally even more losses.