Hedge funds rethink after GameStop pain

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Hedge funds are to revise the way they monitor risk after retail investors sent the price of stocks such as GameStop soaring — triggering big losses for the fund managers that bet against them.

Investors co-ordinating their purchases on Reddit’s WallStreetBets message board were able to drive up the share price of Gamestop, the US video game retailer, from less than $20 at the start of the year to more than $480 by late January, while the prices of some other beaten-down stocks also soared.

For some hedge funds, that proved painful. GameStop had become a favourite target for short sellers — investors betting on a falling share price — which were hit hard when the price shot up. Prominent among them was Melvin Capital, whose assets fell by $4.5bn.

Losses were exacerbated because many funds were crowding into the same trade. Short selling involves of borrowing shares, selling them, and later buying them back in the market, to give them back to the lender. If the price has fallen as anticipated, the trading yields a profit for the short seller. In the case of Game Stop, it did the opposite, and the funds’ simultaneous rush to close their losing bets by buying back the shares only pushed the price higher, in a so-called “short squeeze”.

The episode exposed an unexpected hazard for hedge fund managers in the US and Europe. An industry that has long been associated with hard-nosed tactics towards the companies that it bets against suddenly found itself targeted by retail investors out to inflict serious damage on its members.

That threat has led many to increase the range of tools they use to assess the risks in any potentially dangerous trades. “In the current environment, you are being negligent if you don’t measure and manage your exposure on the short side to both crowding and retail interest,” says Bruce Harington, head of equity long/short strategies at Stenham Asset Management, which invests in hedge funds.

The madness of crowds

In 2008, crowding left less than 6 per cent of VW available to buy © Bloomberg

The dangers of crowding are not new. In 2008, Volkswagen briefly became the world’s biggest company by market capitalisation when fellow carmaker Porsche triggered a short squeeze by unexpectedly announcing that it controlled three-quarters of VW’s ordinary shares. Given other large shareholdings, that left less than 6 per cent of VW’s ordinary shares available to buy in a market where 12 per cent were being shorted. The resulting scramble by short sellers to buy shares to close their positions pushed VW’s share price punitively high.

Such risks will be amplified if retail day traders continue to target short-sellers, whose practice of profiting from companies’ misfortunes has often sparked controversy.

Some prominent investors have responded by adopting a lower profile. In late January, vocal short seller Andrew Left said that his Citron Research would stop publishing research on short positions. He noted that, having started the firm “to be against the establishment, we’ve actually become the establishment”. 

While industry insiders expect activist short sellers to struggle, they do not expect funds to abandon the practice. Short selling remains one of the sector’s most useful tools and some managers believe the excesses created by trillions of dollars of monetary and fiscal stimulus in recent years offer plentiful opportunities to bet against overpriced stocks.

However, funds have started to look at a broader range of information sources to try to stay one step ahead of retail investors.

The head of one multibillion-dollar US hedge fund, who asked not to be named, says it is “absolutely” looking at forums such as WallStreetBets: “We’re monitoring that extremely closely.”

Cutler Cook, managing partner at investment firm Clay Point Investors, says hedge funds have traditionally monitored the risk of short squeezes by looking at the supply and demand for stock lending at prime brokerages, or by looking at a stock’s disclosed levels of short interest and its average daily liquidity. But he says: “New tools and data points like natural language processing and message boards are absolutely being used as a way to monitor for short-squeeze risk, and some are doing so systematically with [web] scraping tools.”

However, while managers are devoting more resources to monitoring these risks, some remain sceptical about the value of trawling through platforms such as Reddit.

“We’ve certainly expanded our data sources during and after [the GameStop squeeze],” says Sushil Wadhwani, chief investment officer at QMA Wadhwani and a former member of the Bank of England Monetary Policy Committee.

Wadhwani says his firm looks at “a variety of media sources”, such as news reports, to gauge what themes are likely to affect share prices, although he has doubts about going as far as scraping blogs. The firm is considering blogs as sources, he says. “But I need to be persuaded. There’s a lot of nonsense.”

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