GameStop frenzy has hedge fund managers rethinking next moves

Retail investors' frenzied attack on short sellers during the week of Jan. 25, which saw U.S. equity trading by volume hit a record high, is forcing some hedge funds to rethink their strategies and approaches to investing.

Sources fear that generating alpha from short positions — and the wider hedge fund industry — may be damaged by the episode. Hedge funds may have to invest more in large-cap stocks rather than small cap, keep their positions better hidden from prying eyes and avoid crowded stocks, sources said.

The recent episode saw a group of retail investors organize what some have labeled a "flash mob" to buy up shorted stocks of companies, including GameStop Corp. The electronics retailer had been one of the most shorted stocks on Wall Street — something the group of investors sought to reverse by buying the stock and driving the price up and in turn hurting hedge funds holding short positions.

The share price jumped 134.8% on Jan. 27, to $347.51 from $147.98 the day before, and was up 788.3% vs. a week before.

U.S. equity market trading hit a record 24.5 billion shares on Jan. 27, according to data from Cboe Global Markets — a record high. The notional value traded was $891.3 billion, the third-highest day ever, behind Feb. 28, at $989.3 billion, and Dec. 18, at $952.8 billion.

There has been a "massive deleveraging that has occurred across the long/short spectrum" as a result of this episode — some voluntary and some in response to pressures from external forces such as profit and loss and prime brokers, James Neumann, New York-based partner and CIO of hedge fund advisory firm Sussex Partners U.K. Ltd., said in an email. "It has maybe gotten a bit manic, but the concern is that the squeezes can be directed at any sector or market cap. Further concern is that this will go more global," Mr. Neumann added.

The episode has brought the future of short alpha into the spotlight, sources said.

"The real question is whether this is a one-off ... or something more structural, which can impact short alpha," Victoria Vodolazschi, New York-based director, investments and hedge fund research at Willis Towers Watson PLC, said in an email. "Hedge funds make money through the process of price discovery and this ability to organize a 'flash mob' potentially means that price discovery can suddenly become irrelevant given unprecedented potential volatility of assets."

That's tough for managers with short-alpha ambitions, since short alpha "is hard to come by in any event," Patrick Ghali, Zurich-based managing partner and co-founder at Sussex Partners, said in an email. The same holds true of market-neutral managers "where moves away from fundamentals can really create problems," he added.

The episode is "forcing (hedge fund managers) to rethink their strategies and tactics," Richard Smith, CEO of The Foundation for the Study of Cycles in Tampa, Fla, said in an email. "It will lead to some strategic and tactical pivots … Tactically they will have to cede some ground in the short term while these Reddit insurgents enjoy their moment in the sun," he said.

The GameStop episode led to a number of changes for hedge fund positions.

SkyBridge Capital II LLC, New York, found that some of the underlying hedge fund managers in its funds-of-funds strategies suffered losses in their short portfolios during the retail investors' attack in the last week of January, but "no one was freaking out," Troy A. Gayeski, partner and co-chief investment officer, stressed in an interview.

Mr. Gayeski said toward the end of 2020, hedge fund managers had taken their risk levels as high as SkyBridge's investment team had seen for some time in response to the results of the U.S. presidential election, continued fiscal stimulus and the coming availability of COVID-19 vaccines.

After the short-squeeze episode, the hedge funds managers SkyBridge invests with significantly deleveraged their portfolios by reducing risk by 10% to 30%, covering their short positions, cutting back their long positions and building up their cash reserves, Mr. Gayeski said.

However, "it looks like the worst is over. When you step back and look at the situation, it was a short-term market move with a fast recovery."

SkyBridge's Mr. Gayeski agreed that long/short equity managers are diversifying their short portfolios by making smaller investments in more opportunities than they usually would.

Mr. Gayeski said long/short equity and multiteam platform hedge fund firms will also be making changes going forward.

"You don't want to be too far over your skis when it comes to your short book," Mr. Gayeski said, adding that hedge fund managers currently are avoiding crowded short bets and moving up the market-cap ladder to invest in or short larger-company stocks.

Mr. Gayeski is also positive on the outlook. He said given the level of volatility in equity markets and high dispersion among individual stocks, "we think 2021 looks like it will offer the best opportunity set we've seen since the late 1990s for strategies like convertible arbitrage." SkyBridge manages $7 billion.

Looking ahead, other sources also expect some of these changes, as well as other tweaks to investment approaches to become permanent.

"We expect that alternative investment managers have begun and/or will look to make changes," Cian Desmond, vice president at Wilshire Advisors LLC in Santa Monica, Calif., said in an email. Potential future changes include short positions having smaller size limits or preset stop-loss parameters, "using technology to scrape social media platforms for indications of growing risk potential" and avoiding crowded stocks where the incremental buyer or seller is less apparent.

"In addition, we expect allocators to prioritize long/short strategies that participate in less crowded or less efficient areas of the equity market with an emphasis on specialized sectors, catalyst-driven investments, or strategies with greater breadth on the short side of the ledger," with a high number of short positions that are individually smaller in size, Mr. Desmond said.

Mr. Neumann thinks this may have a lasting "impact on the large equity long/short sector, particularly affecting those managers" with portfolios containing both the long and short top holdings.

"The more leverage a manager employed, the bigger the problem," so large, highly levered short-term trades will be more closely scrutinized, depending "on how banged up they got," he said. "The managers will be more aware on the short side on what positions may be candidates for a short squeeze. This sits next to the concern about using leverage.

One risk is that "Reddit-reading traders" begin to target all stocks with large short positions in them, David Morrison, London-based market analyst at trading firm TradeNation, warned in an email. "These will tend to be smaller companies where a concerted surge in buying can move the price substantially. But everyone is wise to that now, and if short sellers get hurt, so be it," he said.

But in terms of a silver lining, one consultant, who asked not to be named, said the recent short-squeeze mass retail actions "will have a cleansing effect regarding long/short portfolios and the result likely will be very good investment opportunities going forward."

Another aspect of hedge fund managers' behaviors may be to further limit the amount of information they make public, in efforts to keep short and other positions out of retail investors' hands.

"One thing is certain. Hedge fund managers won't be using their megaphones anymore to broadcast their favorite long/short investment ideas on ... TV, the internet, in written public statements or at conferences. I think we're going to see information coming from hedge funds going underground," the consultant said.

Acknowledging the irony that even as institutional investors almost unanimously support the transparency into hedge fund managers' portfolio holdings afforded by the U.S. Securities and Exchange Commission's quarterly 13-F portfolio filings, the consultant said these filings likely are a source of hedge fund manager investments for retail investors seeking targets.

"These raids by retail investors have made the small-cap market a dangerous minefield for hedge funds, especially those that broadcast their stock picks. This is a bad outcome for hedge fund managers because it makes the small-cap space less efficient and reduces alpha opportunities. It's likely that hedge funds will have to invest more in large-cap stocks," the consultant said. However, this will only be possible where regulation allows. Hedge funds, by law, are required to report certain short positions to authorities. In the U.K., for example, the Short Selling Regulation's minimum reporting threshold for shares traded on a U.K. trading venue was reduced to 0.1% of issued share capital, effective Feb. 1. Prior to that date the minimum threshold was 0.2%. These notifications to the Financial Conduct Authority are private.

However, when net short positions of shares reach 0.5% of issued capital for a traded company, firms must report publicly. Positions are available on the FCA's website.

Jack Inglis, CEO at the Alternative Investment Management Association in London, wrote in a Feb. 1 note to members that "finger wagging at short selling is not new. AIMA and vast troves of independent research have shown time and again that it is useful in the efficient functioning in markets," while major regulators have also acknowledged this, adding that the practice is "tightly regulated."

However, he said that by complying with the rules to disclose meaningful short positions, hedge funds are providing "the open information for others to trade against. The question should be asked as to whether this information has been abused by others to create the huge value distortions that we have just seen in such stock prices. Surely, that is not a healthy marketplace?" he said.

Hedge fund and other money managers have for some time looked to alternative data for signals. Aspect Capital Ltd. has been "focusing hard the last five years" on non-traditional datasets that drive markets, said Asif Noor, London-based portfolio manager. Teams look at various blogs but do not look at social media feeds "as we find them to be quite sporadic. But (we use) blogs, press releases, news sources — to see whether there is a buildup of sentiment."

He said the recent episode is "interesting in terms of bringing out the role that non-traditional datasets play in predicting financial markets."

But with information comes power, and this increased availability of intelligence is one of the factors that has contributed to the GameStop situation.

Andrew Beer, managing member at Dynamic Beta Investments, a New York-based money manager that specializes in hedge fund replication, said in an email that the elements of an episode like this "have been building for some time: access to information, dissemination of knowledge around formerly esoteric trading strategies, nearly costless stock and options trading, (and) a mob mentality in social media. The only lesson for investors here is to avoid clearly crowded trades, whether in stocks or credit instruments," he said.