The short squeeze forced on GameStop and other stocks through Reddit’s WallStreetBets has generated a massive media frenzy against hedge funds and comments all over social media hailing the decision of a group of small investors to trigger a huge repurchase of a beaten-down stock.
The first thing we need to understand is that hedge funds play an essential role in markets. They provide liquidity, and, in many cases, are the ones that buy when the largest proportion of equity and bond markets—long-only investment funds—panic and sell massively.
It’s interesting to see how the average citizen and the media tend to blame hedge funds for market crashes when these investment firms account for less than 3 percent of global assets under management.
When markets crash, it isn’t because of hedge funds’ attacks, but because large long-only funds sell. However, the activity of shorting (borrowing a stock and selling it to repurchase it afterward at a cheaper price) has been demonized numerous times, and usually by CEOs of companies who are missing earnings estimates, underdelivering on their strategy, and destroying value.
Hedge Fund Fallacies
Hedge funds are the easiest scapegoat to blame for the excesses of markets. However, they’re a small proportion of the global market and, more importantly, their main activity isn’t to short stocks or bonds.
There are many fallacies about hedge funds that we read constantly:
- Hedge funds profit from market crashes. The vast majority of hedge funds are net long, which means they have more bets on a rising market than short exposure. In the latest Hedge Fund Review conducted by HSBC, the average net length of hedge funds was 40 percent: a very strong exposure to rising markets.
- Hedge funds are massively leveraged and create distortions in markets. According to a study by Columbia Business School, the average net leverage of hedge funds was 0.59 and the average long-only leverage was 1.36.
- Hedge funds make solid companies collapse. A short position isn’t a guarantee to bring a stock down. As I’ve witnessed as a hedge fund manager, short positions can often be very painful, especially in a rising market, because the risk in a short position is asymmetric: A stock can go up more than 100 percent but can’t fall more than 100 percent. Short squeezes (the process by which hedge funds need to cover their shorts when the price of an asset rises fast and the losses become unbearable) happen more often than people think.
- Hedge funds make concentrated attacks on companies. Collusion is illegal and penalized with jail sentences and heavy fines. Hedge funds have a multitude of different strategies and very different objectives; that’s why one can often find a large hedge fund with a short position in a headline-grabbing stock and a competitor building a long position in that same stock. If one or two hedge funds decided to attack a stock, it’s not just illegal if there’s collusion, but also we would immediately see a large group of investors buying to prove them wrong if the fundamentals and catalysts are positive.
The latest episode of hedge fund-bashing came with the GameStop saga.
Obviously, having a massive short position in a $300 million equity value company with 136 percent of its free float in short interest is a very risky and unprofessional bet.
Most hedge funds use shorts to finance long investments and reduce exposure to market (beta) factors in order to isolate the idiosyncratic value of the investment. If I buy a large technology company for its superb strategy and I want to hedge (hence the name) exposure to interest rates, money supply changes, regulation, or other external factors, I may decide to use a short in a similar, but weaker, technology company. This is what most hedge funds do: not place massive short bets on a bankrupt company that may blow up the risk metrics and performance of the entire fund.
Strict Risk Analysis
It makes no sense to expose an entire portfolio to the risk of a short squeeze. In an ideal portfolio, the hedge fund manager will place risk-adjusted bets on the long and the short side so that one position doesn’t destroy the performance of the portfolio if the bet goes wrong, either because a long investment collapses or a short one rises. Why? Because the manager’s objective is to grow the fund, keep adding names, and attract more investors, thanks to a low-volatility and risk-adjusted strategy.
There’s a lot to be said about those who kept unadjusted bets on GameStop ignoring the daily volumes, the high concentration of shorts, and the diminishing free float. But that’s not what most hedge funds do and is even less what any hedge fund should have as a strategy.
The strategy of a hedge fund is to mitigate volatility and generate absolute returns, adjusting risk limits and keeping strict control of the exposures to different factors. No serious hedge fund manager would finance long positions in liquid names with massive shorts in illiquid and crowded short trades. That person would be fired immediately from a Citadel or Millennium, houses where portfolio managers spend hours on end analyzing risk and exposure limits to be as neutral as possible. Hedge fund managers such as Keith McCullough, Izzy Englander, or Ken Griffin are precisely the ones who promote in their firms a no-nonsense strict approach to risk analysis and specifically weighted factor exposures.
It’s precisely this, the dedicated and strict risk analysis with strong limits to market and external exposures, that differentiates real hedge funds from a “long-only with a few shorts” firms that have unfortunately flourished in a bull market driven by central bank insanity.
Hedge funds have been essential providers of liquidity when markets have crashed, and some of the best and most-talented investors I’ve met in my life have built their careers in the hedge fund world.
Without hedge funds, we would also miss an increasingly rare but essential part of markets: the ones who think outside the box; the investors who actually identify bubbles and excessive risk in a world where all we hear every day from consensus is that nothing is bad and markets can only go up.
Bad Strategies Exposed
GameStop has exposed a few bad strategies but not destroyed the true value of a well-hedged and low-risk long-term portfolio with quality longs and good sources of funds hedging them. There’s nothing in the GameStop saga that debunks the proven strategy of so many really market-neutral hedge funds.
The GameStop saga only proves three things:
- There are too many people taking excessive risk due to the insane monetary policy we live in, including the alleged Robinhood investors trying to force short squeezes on bankrupt companies.
- It’s amazing to see that the same people who, rightly, are critical when there’s an episode of collusion between investment firms are hailing the ultimate collusion promoted by a website that moves 197 million shares of a stock in one day and wants us to believe it’s all the action of a few young investors who decided that a bankrupt company is the place to put their hard-earned savings.
- A short squeeze is relatively easy to trigger. The problem, as so many will find, is to sell afterward.
Small investors benefit a lot from websites where they share ideas and opinions. Colluding to trigger short squeezes in an almost-bankrupt company may seem fun, but it’s behaving in the same casino-like, foolhardy way that many of these investors accuse others of doing.
If you want to invest, learn from the successes achieved by great investors and the mistakes committed in their analysis of companies; don’t play the greater fool theory and hope for the best.
Learn from the best, not from the reckless.
Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.