Hedge Fund Pressure Lingers With Short Sellers’ Targets Rallying

Trades associated with hedge funds were under pressure again in Friday’s stock selloff, though with less intensity than earlier in the week.

The most visible evidence was a rally in companies with the highest short interest, a basket of which climbed 2%, according to data compiled by Goldman Sachs Group. Names that had burned bearish hedge funds, from GameStop Corp. to AMC Entertainment Holdings Inc., bounced back after some brokerages lifted trading restrictions on the shares.

Elsewhere, an exchange-traded fund tracking the industry’s favorite stocks (GVIP) fell about 2%, roughly in line with the market.

Hedge Fund Pressure Lingers With Short Sellers’ Targets Rallying

While the pain paled in comparison with Wednesday, its persistence is a continuation of this week’s theme, in which professional investors have suffered at the hands of day traders banding together in chat rooms. Despite a rush to cut risky bets in a process known as degrossing, hedge fund selling has yet to reach levels that signal the cycle is over, according to data compiled from Morgan Stanley’s prime brokerage unit.

Hedge Fund Pressure Lingers With Short Sellers’ Targets Rallying

“While we may not follow the same pattern this time, the main point is that several big days of degrossing are not always the ‘end’ of the period as degrossing usually persists, but typically in lesser magnitude, for several weeks to months after,” the firm wrote in a note. “Historically, there’s been continued active degrossing that occurs after the initial shock.”

With day traders waging war on heavily shorted stocks, professional speculators have been forced to dump holdings on the long side of their portfolios. Still, gross leverage, a measure of industry risk appetite that takes into account both bullish and bearish wagers, remained elevated, partly because the short side of the book kept swelling because of a rally in shares such as GameStop. At above 200%, leverage is near all-time highs, Morgan Stanley data show.

At Goldman, clients experienced the biggest one-day decrease in gross leverage on Thursday. Still, at 237%, leverage sat in the 96th percentile of a one-year range.

Hedge Fund Pressure Lingers With Short Sellers’ Targets Rallying

At JPMorgan Chase & Co., client degrossing also seemed limited, with four-week flows having yet to register as a 1 standard-deviation event. While the size of covering in highly shorted stocks would suggest it’s closer to an end, it isn’t clear that bears broadly have been exhausted, according to a JPMorgan note.

“The bigger risk seems to be where the recent long selling that started in earnest this week has to persist for a while longer,” JPMorgan wrote. “The fact that this is not occurring during a broader market weakening in the macro backdrop makes it harder to gauge how much further this should go.”

Industry titans including Point72 Asset Management, D1 Capital and Melvin Capital have been bruised this month as retail traders have driven up the price of popular hedge fund shorts. The losses seen over the last few days may rank as among the worst in some of the managers’ careers.

To Victoria Fernandez, chief market strategist at Crossmark Global Investments, the endurance of pros at some level depends on how long these growing groups on Reddit’s WallStreetBets forum will hang on to their strategy of wagering on the heavily-shorted stocks.

“It’s almost like it’s a game to them -- where can they get in and stick it to Wall Street,” Fernandez said. “If this grows then in order to cover these shorts, a lot of these people are going to have to start selling some of their more liquid holdings.”

With hedge funds’ favorite stocks heading for the worst week since October and most-shorted shares poised for the most painful month for short sellers, existential questions may arise for some in the hedge fund industry, according to Christopher Grisanti, chief equity strategist at MAI Capital Management.

“The market was freaked out because they were unclear about these hedge funds and what their cash needs were,” Grisanti said. “That’s when the market gets concerned there would be a spillover to more widely held stocks but I don’t think that is long lasting.”

©2021 Bloomberg L.P.

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