As dust settles on GameStop carnage, hedge funds ponder lasting impact of ‘Reddit raid’ on short selling
The co-ordinated billion-dollar raid on hedge funds’ short positions in GameStop by amateur traders represents another risk management factor in a battalion of emerging challenges that now confront managers’ portfolios, industry participants say.
But while the swoop was neither the first nor the last short squeeze to hit the hedge fund sector, the aggressive and well-organised nature of the price push – which drew in sizeable amounts of leverage and the widespread use of online retail platforms – was a unique process which raises new questions surrounding financial regulation, market functioning, position sizing and the growing role of online trading platforms in the price discovery process.
Following the initial share price surge in the Texas-based video game store chain, which dealt billions of losses to a number of short sellers, the subsequent slump in targeted names brought home the brutal realities of the market, leaving retail investors counting the cost of the frenzy.
As the dust settles on the saga and hedge funds cautiously step back into risk assets, Hedgeweek rounds up a range of views from across the spectrum on how the past seven days upended markets, and considers the long-term implications for the industry.
One long/short equity manager suggests the episode has shed light on the growing issue of crowding and concentration in hedge funds, both across portfolios and within certain handfuls of stocks.
“Anecdotally, hedge funds’ positioning has become ever more concentrated in recent years,” the manager told Hedgeweek. “Generally speaking, hedge funds have been long TMTs and short consumer. But GameStop had 140 per cent of its freeflow shorted – from a hedge fund point of view, that’s not very smart. So this was arguably foreseeable,” the manager explained.
“But what people didn’t foresee was that it would be retail investors launching the attack. That was unusual. And what’s different this time round is that it is more coordinated.”
He added: “When you get coordinated targeting of 10 or so stocks, with huge leverage compared to the actual investments, the secondary effect was panic. This was largely contained to the hedge fund world where you saw hedge fund managers panic over whether they could be [positioned short] in the next GameStop. So there was a lot of short covering.”
Faced with the heightened risk of future short squeezes, managers of varying strategies expect to keep ever-closer tabs on retail platforms and flows than in the past, in order to ensure they are not in positioned in any potential future targets, say industry observers.
Julien Messias, portfolio manager and co-founder of French systematic hedge fund Quantology Capital Management, said the symmetry in markets between buying and selling orders, and the safe access to markets provided by brokers and trading platforms, had been upended by the recent GameStop frenzy.
Reflecting on what was seen as a “David against Goliath” battle, Messias warned that some smaller investors, having “crushed” a larger name, may become addicted to such behaviour further down the line.
That, in turn, raises bigger questions among managers relating to risk management in hedge fund structures, and the increased dangers of shorting stocks - particularly those names that are already heavily shorted, or ones with “symbolic meanings”.
As the focus turned to Reddit’s WallStreetBets discussion board over the course of the week, managers are now increasingly alive to the rapid growth of such platforms, and their continuing power to move equity prices, according to Ayush Ansal, chief investment officer of systematic equity hedge fund Crimson Black Capital.
“It is important to distinguish that while the media has branded Reddit traders to be teenagers gambling with small amounts, it is not wise to ignore the immense number of professional traders watching the forum and driving significant demand massively leveraged through call options,” he explained.
Ultimately, the GameStop chaos has offered a strong reminder than stock prices are, in the end, “nothing more than an outcome of demand and supply”.
“Attributes such as fundamentals and technicals are only valuable if they form the decision-making basis for most of the participants in the market,” Ansal said, adding that GameStop presented a “unique situation” in which there was only one metric that generated demand: short interest.
He believes computer-driven hedge fund strategies – so often caught on the wrong side of such fast-paced market moves – would not likely have touched GME due to the “extremely high short interest”, which makes being both long and short “unattractive from a systematic point of view.”
“The massive volatility forced risk cuts across the board which is another reason why, even with the extreme performance, from a portfolio management perspective, a position in GME is not attractive,” Ansal noted.
He added: “The goal should be to deliver consistent returns rather than trying to win the lottery. This is not the first time most professionals have seen a bubble and it will not be the last.”
Weighing up the broader implications for markets, Jack Inglis, CEO of the Alternative Investment Management Association, maintains that hedge fund managers are finely attuned to the asymmetric risk of taking short positions, noting that those exposed will have “taken it on the chin” and made necessary steps to contain losses.
New analysis this week suggests the coast may now be clear for hedge funds to once again ramp up risk positions, as retail traders lick their wounds.
But Inglis warned: “What we have witnessed in the past week is a game that has led to a gross distortion in both efficient market functioning and true price determination. If that is to continue, we will all be the poorer for it, including those who are clapping the loudest.”
In a market commentary, BlueBay Asset Management CIO Mark Dowding said that although risk premia could be squeezed by the recent behaviour, posing wider problems for financial stability, recent volatility indicators suggest “there is healthy scepticism in markets and an instinctive desire to protect downside.”
“Hedge funds may cry foul at these Robin Hood-inspired tactics, but recent success on the part of these investors seems destined to lead those exposed to unlimited losses - by being short of ‘right-tailed’ risk - to question the viability of their investment strategies,” Dowding wrote.
With many observers branding the GameStop fiasco a market manipulation, attention is now turning to what the US Securities and Exchange Commission’s response will be.
Ayush Ansal said: “Most professionals agree that decentralized pump-and-dumps hosted on anonymous message boards present a unique threat to market structure,” added Ansal. “Having grown from a casual options speculation chatroom of a few hundred thousand users, the forum has now morphed into a beast that is the number one sub-Reddit with 8.5 million subscribers.”
“No-one’s investing in these stocks on a fundamental basis. No-one thinks there’s real value in GameStop or American Airlines. They’re simply driving share price up to make a profit. It’s pump-and-dump. It’s pretty blatant,” observed one equity manager, who predicts some form of regulatory clampdown on retail platform activity further down the line.
The equity manager said: “What hedge funds can’t do is go on forums anonymously and pump up stocks, whereas these people can. The fact that it happened once should certainly lead you to the conclusion that it could happen again, unless regulators step in to prevent it.”