No, we do not believe that is generally the case. While the recent wild ride of a few companies’ share prices was novel in that it was coordinated by retail investors on the social media platform Reddit, the short coverings that contributed to the price spikes were all too familiar to long-time investors. To help guard against further retail-driven disorder, investors should focus on four key risks in a hedge fund manager: leverage, illiquidity, concentration, and basis.
Hedge fund investors have witnessed short squeezes many times in the past. In October 2008, Volkswagen surged more than 400% in two days, becoming the most valuable company in the world briefly. The car company was a widely held short position, and the rise in its stock price prompted many hedge funds to unwind short positions, pushing Volkswagen’s stock price even higher. GameStop, which was the most extreme mover of the recent Reddit-linked tumult, similarly advanced 400% in a short period of time to a market capitalization approaching $40 billion.
But just as quickly as prices rise, they topple. In the four days after Volkswagen’s share price peaked, it dropped 58%. GameStop was no different. It has collapsed more than 80% since late January. In prior years, multi-manager platforms and quantitative equity shops were often blamed for the chaos rather than retail investors. While all deleveraging episodes have generally been painful, they’ve also tended to be short-lived and isolated.
With all deleveraging events comes reflection and reassessment of risk tolerance. Some long/short equity hedge funds will modify short portfolio characteristics, such as short position liquidity, percent short-interest limits, and max-position sizing. Historically, managers may have also reevaluated other risks, including asset/liability mismatches and factor misbalances between styles, market capitalizations, and geographies. But the Reddit-driven short squeeze was largely an anomaly, with only a few managers experiencing large drawdowns. Furthermore, the aggregate short interest in US equity markets is at its lowest level since 2000, suggesting broad-based deleveraging likely isn’t in the cards.
Still, the recent Reddit-linked disorder was unique in that it was retail-driven. In recent years, retail investors have become larger players in the US equity market. During COVID-19, so-called retail day-traders have become a larger percentage of daily trading volume, garnering the attention of financial news media networks. Whether the retail investor trend loses momentum as lockdowns are lifted remains to be seen. In any case, while social media’s long-term impact on financial markets is uncertain, it seems reasonable that it may amplify market trends.
A key unknown factor is how regulators choose to respond. To be sure, retail investors coordinating investment decisions on Reddit has garnered the attention of US authorities. Given the isolated damage from this most recent deleveraging, we doubt the hedge fund industry will face new onerous regulations, unless additional regulations are imposed to make shorting more challenging. But any new regulations are likely to be discussed in a more public fashion, unlike the short bans of 2008.
Stepping back though, the recent hedge fund deleveraging was a reminder of some core tenets we value in our manager selection process. We have generally avoided managers that take excessive amounts of leverage, illiquidity, concentration, or basis risks. Large exposures to any of these four risks often lead to large drawdowns. The ability to survive irrational markets by limiting drawdowns is critical to the long-term success of any investment manager. Given that the average hedge fund liquidity terms don’t allow for daily redemptions, investors must remain highly disciplined in their due diligence process. If investors lose this discipline the next deleveraging may result in a permanent impairment of capital.