In Defense Of Hedge Funds – Gamestop Squeeze Hides Market Excess Risk

Authored by Daniel Lacalle,

The short-squeeze forced in 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 is interesting to see how the average citizen and the media tends to blame hedge funds for market crashes when these investment firms account for less than 3% of global assets under management.

When markets crash it is not because of hedge funds attack, but because long-only large 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 that are missing earnings, underdelivering on their strategy, and destroying value.

Hedge Funds are the easiest scapegoat to blame for the excesses of markets. However, they are a small proportion of the global market and, more importantly, their main activity is not to short stocks or bonds.

There are many fallacies about hedge funds that we read constantly:

1. Hedge Funds profit from market crashes. The vast majority of hedge funds are net long, which means that 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 is 40%, a very strong exposure to rising markets.

2. 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 is 0.59 and the average long-only leverage is 1.36.

3. Hedge Funds make solid companies collapse. A short position is not a guarantee to bring a stock down. As I have 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% but cannot fall more than 100%. 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 what people think.

4. Hedge Funds make concentrated attacks on companies. Collusion is illegal and penalized with jail sentences and heavy fines. In reality, hedge funds have a multitude of different strategies and very different objectives, that is why often one can 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 is not just illegal if there is collusion, but immediately we would see a large group of investors buying to prove them wrong if 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% 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.

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 does not 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 is a lot to be said about those that kept unadjusted bets on Gamestop ignoring the daily volumes, the high concentration of shorts, and the diminishing free float. But that is 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 a 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 analysing risk and exposure limits to be as neutral as possible. Hedge fund managers like Izzy Englander or Ken Griffin are precisely the ones that promote in their firms a no-nonsense strict approach to risk analysis and specifically weighted factor exposures.

It is precisely this, the dedicated and strict risk analysis with strong limits to market and external exposures that differentiate 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 have 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 that think outside the box, the investors that 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.

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 is 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.

a) There are too many people taking excessive risk due to the insane monetary policy we live in, including the alleged Robin Hood investors trying to force short-squeezes in bankrupt companies.

b) It is amazing to see that the same people that -rightly- criticize when there is an episode of collusion between investment firms hailing the ultimate collusion promoted by a website that moves 197 million shares of a stock in one day and wants us to believe that it is all the action of a few young investors who decided that a bankrupt company is a place to put their hard-earned savings on.

c) A short-squeeze is relatively easy to trigger. The problem, as so many will find, is to sell afterward.

Small investors benefit a lot more from websites where they share ideas and opinions. Colluding to trigger short-squeezes in an almost-bankrupt company may seem fun but it is behaving in the same casino non-fundamental insane way that many of these investors accuse others of implementing.

If you want to invest, learn from successes achieved by great investors and the mistakes committed by them analyzing companies, do not play the greater fool theory and hope for the best.

Learn from the best, not from the reckless.