Big investors, hedge funds need to adjust to ‘new normal’

The unprecedented monetary and fiscal stimulus in response to Covid and the global financial crisis before that has pushed retail investors and hedge funds alike to take more risk.

GameStop is in the middle of a pitched battle. Picture: AFP

The possibility of market manipulation behind US stock ramps that have squeezed hedge funds this year has sparked calls for an investigation by the Securities Exchange Commission and the powerful US House Financial Services and Senate Banking committees of Congress have called hearings into why brokers saw fit to take steps to curb retail buying of the stocks that were being squeezed.

But while the unprecedented monetary and fiscal stimulus in response to Covid and the global financial crisis before that has pushed retail investors and hedge funds alike to take more risk in a world of near zero returns on safe assets, a little common sense in all round would go a long way.

Asset liquidation as a result of losses on short positions by hedge funds weighed on the broader share market this week, with Australia’s S&P/ASX 200 index down 2.8 per cent. Additionally, iron ore miners were hit by China’s pledge to cut steel output this year, even as the February earnings period promised to deliver windfall profits and dividends from the massive rise in iron ore prices last year.

Financial markets observers were shocked this week when a major US hedge fund, Melvin Capital Management, took a $US2.75bn ($3.6bn) bailout from two other hedge funds after losing 30 per cent of its $US12.5bn of capital this year on short bets on US companies including GameStop.

GameStop shares had surged 300 per cent in the first three weeks of the year, driven up alongside other heavily shorted stocks including AMC Entertainment, Blackberry and Bed Bath & Beyond, at the urging of Reddit’s popular wallstreetbets forum. At that point, Melvin Capital had lost 15 per cent of its capital according to The Wall Street Journal.

Two days later, Melvin’s cut its short on GameStop as its loss doubled after the share price rose as much as 669 per cent for the year, or about 15 fold from the time in late October when users of the Reddit forum started plotting “the demise of Melvin Capital.”

By Thursday, GameStop had reached a record high of $US483 a share.

Despite no change in its fundamentals, GameStop rose 41 fold or 4687 per cent in three months.

Broker restrictions on buying sparked a 77 per cent intraday dip from there.

But in after hours trading on Thursday GameStop surged 61 per cent as brokers said they would accept buys.

Because US brokers including Robinhood raised margins and temporarily banned buying of several stocks that were squeezed, there were lawsuits, even though the brokers were within their rights.

Critics see a double standard. They feel the regulators and brokers behave as if it’s okay for hedge funds to contribute to corporate destruction via short selling, but it’s not okay for a group of like-minded retail investors on Reddit to contribute to hedge fund destruction by betting against them.

But they assume that the brokers were working to protect the hedge funds, while ignoring the risks for the brokers, let along the retail punters, of taking more buy orders in stocks that could easily collapse within a day. The short interest in some including GameStop was over 100 per cent.

The explosive rise in the share prices of GameStop and others led the SEC to warn that it was “aware of and monitoring the on-going market volatility in the options and equities markets and consistent with our mission to protect investors and maintain fair, orderly, and efficient markets, we are working with our fellow regulators to assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants.”

No doubt other hedge funds are struggling to get out of short bets in companies like GameStop.

On Thursday, the New York Times said Melvin backer, Point72, run by hedge fund titan Steven A Cohen had suffered a 15 per cent loss over the GameStop short squeeze.

But the takeaway for medium-term investors from this week’s turbulence is that those betting on stocks going down – even bad stocks – are losing money because of the unprecedented fiscal and monetary policy support. Even if their losses spark some selling at times, the trend is still up.

Moreover investors, traders and regulators alike need to adapt to the “new normal” of financial markets - including zero interest rates, zero commissions and the power of social media.

Central banks and governments won’t deviate from the path they’re on while the pandemic is raging and social media, mainstream media and analysts won’t stop promoting certain stocks.

“If you’re shorting stocks like these hedge funds were, generally it’s a short-term trade, if you are trading over the short-term, you should monitor what the media outlets are saying,” said Hasan Tevfik, Senior Market Analyst at MST Marquee. “Now you can add Reddit to your list.”

For the hedge funds involved – supposedly some of the best in the business – one also has to question their logic of staying short of stocks that were already so heavily shorted.

It’s a basic rule of trading to avoid such crowded bets, particularly in stocks with small market capitalisation.

“There are a few reasons why I wouldn’t have been short GameStop,” said Omkar Joshi, Principal and Portfolio Manager at Sydney-based hedge fund, Opal Capital Management.

“Firstly, the short interest on GameStop was above 100 per cent, which tells you that it’s absolutely not a unique idea – it was a very crowded trade – so if anything positive comes out, or the stock price starts to move higher, a short position could come under substantial pressure as numerous investors look to close their positions at the same time for risk management purposes. If you still wanted to be short, you would want to have only a very small position given these dynamics..

To have the conviction to short something when there’s more than the total number of shares on issue already sold short, you are basically saying that you have complete conviction that the share price will go lower.

The other thing is that it used to be quite a small company and therefore liquidity can pose an issue. I would put it down to poor risk management in regards to position sizing given the potential for significant losses if the trade went wrong.

Another hedge fund manager said that while there’s little doubt that many companies with weak business models will go bankrupt as policy support abates, it has so far been risky betting against even some of the more vulnerable-looking companies.

“There’s an artificiality in incomes, spending and corporate earnings at the moment,” he said.

“But what we’re seeing with the retail bets against the hedge fund shorts is a bi-product of zero rates and money printing and the escapism of the average retail punter.”