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Hedge funds are still licking their wounds after a retail trading frenzy forced the industry to slash its overall exposure to stocks, leading to an underperformance in 2021.
Last month, an army of retail investors who coordinated on social media managed to push GameStop shares up 400% in just one week, creating massive squeezes in a slew of heavily shorted names. Hedge funds getting burned on their short positions scrambled to take down overall risk and sell winners to raise cash.
This kicked off a domino effect that led to hedge funds’ largest week of de-leveraging since February 2009, according to data from Goldman Sachs’ prime brokerage unit.
The dust has yet to settle as the damage inflicted by the so-called dumb money seems to be lasting. The 20 most popular long positions among hedge funds have lagged the S&P 500 by more than 1% year to date on average, according to RBC’s analysis of 330 hedge funds based on the recent regulatory filings.
“It is partly due to hedge fund degrossing in January as hedge funds reacted to the retail trading frenzy that gripped equity markets,” Lori Calvasina, head of U.S. equity strategy at RBC, said in a note. “The impact from January hedge fund degrossing has more than offset the recovery in performance seen from late January through mid February.”
Meanwhile, amateur retail traders, often scolded for their lack of sophistication compared to Wall Street pros, are building on their momentum even after most of the short squeezes are completed.
A basket of retail favorite stocks has rallied 18% this year, outperforming a basket of the most popular hedge fund long positions by eight percentage points and the S&P 500 by four percentage points, according to Goldman.
This David versus Goliath battle came at a particularly vulnerable time for hedge funds. Professional traders had already gotten caught in a big market rotation out of their tech darlings and into cyclical names amid an economic recovery. Growth-loving hedge funds are still underweight energy and financials, two of the biggest winners this year with a rally of 25% and 10%, respectively.
Record leverage
The GameStop mania also highlighted the hedge fund community’s Achilles’ heel — a high level of leverage and concentration. Hedge funds entered the new year with the highest levels of net and gross exposure on record, according to Goldman.
“The January short squeeze illustrated how the combination of leverage and crowding creates risk both for hedge fund returns and broad market performance,” David Kostin, Goldman’s head of U.S. equity strategy, said in a note.
Hedge funds’ portfolio concentration and the degree of crowding also remained elevated historically, Goldman’s data showed. The top five most owned stocks by hedge funds — Amazon, Microsoft, Facebook, Alphabet and Alibaba — have remained the same for 10 consecutive quarters, Goldman said.
Still, not all hedge funds emerged battered from the short squeeze saga and the ones that dodged the bullet tend to be more careful about taking on risk.
Third Point’s Dan Loeb, whose hedge fund sidestepped steep losses caused by the GameStop mania, said in a Feb. 10 letter to investors that he always felt more comfortable with higher net and lower gross exposure, meaning his fund tends to have bigger long positions than short.
Loeb also said he learned his lesson betting against names with outsized short interest.
“After a few previous painful experiences of our own taking positions against companies with large short interests, we had a preview of what can happen and cut our losses,” he said in the letter.
— CNBC’s Michael Bloom contributed reporting.
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