Hedge funds rethink tactics after $12bn hit from meme stock army

Hedge funds that bet on falling share prices are stepping up their efforts to spot the next GameStop after this year’s “meme stock” bonanza left the industry nursing billions of dollars of losses in just six months.

Huge gains in the price of companies favoured by day traders who assemble on message boards such as Reddit caught out some short sellers badly in late January. In recent weeks, these stocks have staged a second rally, with a rise in stocks including cinema chain AMC inflicting yet more pain.

Hedge fund losses since the start of the year from betting against just GameStop, AMC and Bed Bath & Beyond total more than $12bn, according to data group S3, while bets against a number of others have each run up additional losses of hundreds of millions of dollars. More than half short sellers’ $5.1bn of losses betting against AMC this year have come in June.

The heavy toll shows how moves by individual investors, which are regularly co-ordinated on forums such as r/WallStreetBets, has heightened the risks for professional investors in the Wall Street equities market.

“In two waves, a few hedge funds have seen modestly sized short positions turn into extinction-level events,” said Andrew Beer, managing member at investment firm Dynamic Beta Investments. Funds that suffer multiple rounds of losses on short bets “will face difficult questions from investors as to whether their risk management failed to adapt to a changed market environment”.

The highest-profile hedge fund casualty has been Melvin Capital, which lost 53 per cent in January and is still down 44.7 per cent this year to May. Light Street Capital, the fund led by ‘Tiger cub’ alumnus Glen Kacher, was also hit early this year and again in May, with losses in the first quarter predominantly driven by soured short bets. London-based White Square Capital, which lost money shorting GameStop, is also shutting its main fund.

An index compiled by Goldman Sachs of stocks favoured by retail investors has almost doubled since June 2020, while another that tracks companies that are targeted by short sellers has gained 28 per cent.

Traders across the industry, both those caught directly in abrupt rallies in heavily shorted stocks as well as those hit by the ensuing market volatility, have now been forced to start tracking potential retail investor manoeuvres, or risk huge losses and backlash from their investors. 

“The danger is you don’t really know what stock the retail community is going to go after next,” said Amy Wu Silverman, equity derivatives strategist at Royal Bank of Canada. “There is not a stock that is ‘safe’.”

Wu Silverman had typically concentrated on advising institutional clients about their hedging strategies. Now hedge funds seek her help to identify the early warning signs of a retail-driven meme stock surge.

“It has completely upended our markets, and we have had to make really dramatic changes to how we model things and how we manage risk,” she said. Retail investors chasing volatility “has gotten to the point where you can’t ignore it”.

Losses inflicted by retail investors have proved a rude awakening to hedge funds, which had just enjoyed a banner year in 2020 making their biggest gains since the aftermath of the financial crisis, according to HFR.

Some funds are considering taking a greater number of smaller short positions to cut down on the potential losses a single stock can cause, say industry insiders. D1 Capital, whose founder Daniel Sundheim previously worked at Viking, is one fund that has been considering reducing the size of short bets this year, say people familiar with the strategy. Others are looking at betting against indices, rather than individual stocks.

Managers in the US and UK have begun using algorithms to scour forums such as r/WallStreetBets or other data sources to try to spot co-ordinated buying. While the practice is new to most western funds, this kind of surveillance is already common for many Asian managers, according to Patrick Ghali, managing partner at advisory firm Sussex Partners.

Tiger cub Lee Ainslie’s Maverick Capital wrote to investors in April that its quant team “now systematically monitors Wall Street Bets and other similar forums that cater to less experienced, retail investors”. Moez Kassam, chief investment officer at Anson Funds in Toronto, said his firm has been building algorithms to follow commentary and sentiment on Reddit, as well as using some bought from external companies.

Fintech company S3 now provides a company’s “short squeeze risk” score to Bloomberg terminal users, while alternative research provider Quiver Quantitative scrapes Reddit investment threads for ticker mentions and sentiment.

“You don’t want your book to be exposed to the whims of r/WallStreetBets,” said Quiver founder James Kardatzke.

Data group Sentifi, which buys data from the likes of Reddit and Twitter and uses it to score sentiment around stocks, said it detected a nearly 1,200 per cent rise in chatter around AMC between May 20 and June 1. The cinema chain’s shares had already started to rise by then, but then doubled on June 2. Sentifi said the number of customers using its platform had doubled over the past year.

Swiss investment firm Unigestion has also started looking at how it can deploy its machine reading and data techniques — which it already uses to spot changing sentiment — around meme stocks.

“It is an important, though short-term, risk factor” in markets, said Unigestion portfolio manager Salman Baig. “For us, any factor that can disrupt markets is of primary concern.”

Additional reporting by Miles Kruppa

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