GameStop Furor Inflicts Lasting Pain on Hedge Funds

(Bloomberg Opinion) -- Whatever happens next in the GameStop Corp. saga, the blow to hedge funds is real and won’t be absorbed easily.

Last week was a bad one for long-short equity hedge funds, so called because they simultaneously bet on some stocks (long) and against others (short). In what has become the shot heard around the investing world, a posse of retail investors who found one another on Reddit piled into shares of GameStop and a handful of other stocks, driving up prices and handing losses to hedge funds that bet against them.

The magnitude of those losses is coming to light, and it isn’t pretty. At the center of the pain is Melvin Capital, a hedge fund that bet aggressively against GameStop. Melvin lost about 53% in January on the gaming retailer and other short bets, according to reports on Sunday. And it’s not alone. Mets owner Steve Cohen's hedge fund, Point72 Asset Management, has reportedly lost 15% this year during the Reddit revolution, in part from its investment in Melvin. Hedge fund D1 Capital Partners, which is an investor in trading app Robinhood Markets, lost roughly 20% last month.

Long-short hedge funds aren’t supposed to lose that much money. Their reason for being is to rack up gains, or at least hold their ground, no matter what the stock market throws at them. That’s how it played out when they rose to fame during the dot-com bust in 2000. While the stock market declined for three consecutive years from 2000 to 2002, hedge funds continued to make money because the profits on their shorts more than offset the losses on their longs. But so far this year, it’s been just the opposite. Many hedge funds are down sharply even though the market is roughly where it started the year. 

In fairness to Melvin founder Gabe Plotkin and other managers caught in the GameStop crossfire, no one could have seen this coming. Sure, in hindsight Melvin should have had a less aggressive bet against GameStop, but it was a relatively modest wager in Melvin’s larger portfolio. Who could have imagined that a pack of retail investors would drive up shares of GameStop 25 times in a handful of days, motivated in part by a desire to ruin Melvin and other hedge funds?  

It’s hard to hold that against Plotkin, which is probably why more money appears to be flowing into Melvin than out even after its devastating start to the year. Point72 and Citadel LLC pumped $2.75 billion into the hedge fund last week, along with current clients who are reportedly adding to their investments.  

But now that the threat is in full view, hedge funds can’t ignore the possibility, however remote, that their shorts will be targeted, particularly when the Reddit mob is threatening more trouble. Melvin, for one, isn’t taking any chances. It has drawn down its leverage to the lowest level since its founding in 2014 and has “repositioned the portfolio,” including covering its short on GameStop, according to a source familiar with the fund. And here, too, it’s not alone. As my Bloomberg News colleague Tracy Alloway tweeted overnight, “Last week was the largest active hedge fund deleveraging event since February 2009, with long positions sold and shorts covered in every sector,” according to Goldman Sachs.

That leaves long-short hedge funds with some unappealing options. If they abandon their shorts, then they lose their hedge. Who wants to pay sky-high hedge fund fees — traditionally a 2% management fee and 20% of profits — for a long-only stock portfolio that can be had for a fraction of the cost through a mutual or exchange-traded fund? And if they try to protect their shorts using options and other derivatives, the cost will drag down returns, possibly as much as 3% to 5% a year. After more than a decade of disappointing performance, they can ill afford to squander precious percentage points. 

There’s also a more immediate threat. So far, the stock market has been unfazed by the showdown between hedge funds and retail investors. If that continues, one can easily imagine a scenario in which the market moves sideways or higher while hedge funds take more losses, which won’t win them many fans. Hedge funds are supposed to protect investors from the vagaries of the market, not the other way around.

Nor can regulators easily ride to hedge funds’ rescue. After the government bailed out corporate America in 2008 and left ordinary Americans to fend for themselves, many people believe the game is rigged in Wall Street’s favor. Against that backdrop, regulators won’t want to appear to side with hedge funds. They also can’t hold Redditors to a different standard than everyone else, so unless the Reddit mob has broken any rules, it’s hard to see how regulators can prevent them from targeting hedge funds. 

And based on what we know so far, it doesn’t appear as if Redditors have crossed the line. They are most often suspected of market manipulation, but there’s little indication of that, at least as manipulation is generally understood. As long as Redditors are not trying to interfere with the normal trading of GameStop’s stock, they’re free to talk up and buy the shares for any reason, including inflicting pain on hedge funds who bet against it. 

Of course, all of that could change quickly. Lawmakers and regulators are promising to investigate, so more details will emerge. It would also be a mistake to underestimate hedge funds. They have the brains, money, resources and plenty of incentive to fend off threats to their 2 and 20. And the Reddit mob might disperse.

Still, however this saga ends, the world will never be the same for long-short hedge funds. A lot of people are fixated on GameStop’s stock, even if they don’t have any money it. I can tell you how, if not when, that story ends: The stock will go up and then it will fall; some people will make money and others will get squashed. But if you want to see some real drama in the days ahead, keep an eye on what hedge funds do next.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

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