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.