In Defense of Hedge Funds. Gamestop Squeeze Hides Market Excess Risk

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 Keith McCullough, 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.

About Daniel Lacalle

Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Author of bestsellers "Life In The Financial Markets" and "The Energy World Is Flat" as well as "Escape From the Central Bank Trap". Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Frequent collaborator with CNBC, Bloomberg, CNN, Hedgeye, Epoch Times, Mises Institute, BBN Times, Wall Street Journal, El Español, A3 Media and 13TV. Holds the CIIA (Certified International Investment Analyst) and masters in Economic Investigation and IESE.

17 thoughts on “In Defense of Hedge Funds. Gamestop Squeeze Hides Market Excess Risk

  1. FUCK OFF SHIT BRAIN. Market Markets “who provide liquidity” are not supposed to use their status to naked short. THAT IS ILLEGAL even if the shits at SEC and Justice have never prosecuted a single hedgie who COUNTERFEITS shares in this way diluting the value of honest holdings, sometimes destroying companies in the process. Your sociopathic buddies profited handsomely form this illegal activity, that is until some clever and not too honest LICENSED FINANCIAL PROS caught on to the numbers that were involved. A Registered Representative named Keith Gill hid his identity in YOUTUBE videos while telling people how they could destroy these evil Hedgies and create the mother of all short squeezes. A very clever (and also illegal) pyramid scheme was created to attack the shorts by getting a lot of people to climb on the trade and buy GME hand over fist and HOLD without regard to price or cost basis. Getting the small guys to climb on the trade allowed the initial money like Gill’s to ride and leave the trade with huge profits while everyone else is still screaming HOLD HOLD HOLD! This is just one group of degenerate “initiates” using the cover of anonymous internet troops to take down the degenerate competition. Both sides are dirty with useful idiots and bag holders sandwiched in between. Gill may have already closed out his positions while encouraging his meme army to fight on! One Robinhood share at a time! ROFLMFAO! Hell, Keith Gill the LICENSED PRO conman who started this all may have already taken some of his squeeze profit and put it into puts! Gill has series 7, 24 and 3 licenses so this is so illegal I cannot believe he hasn’t been cuffed yet. Maybe he is still free because if you arrest him you have to explain in court why you allow Hedgies to counterfeit stock in order to short it, among other ignored illegalities! SEC is surely screwed no matter what they do or who they go after here.

  2. This is just the beginning. No matter where they hide we can counter their position. A little at a time we destroy the wealth gap.

  3. HEY SHIT BIRD, a company cannot have 136% of its free float in short interest unless someone cheats.

    There are some players in the market who have “market maker” status but also trade their own books or have cross-interests with those who do. Allegedly there are “Chinese walls” between those pieces (or interconnected entities.) Quite obviously that is a load of crap because otherwise what you’ve seen would be impossible but it clearly not only has happened before but is still happening to this day. These entities are how you wind up with short sales where the locate and borrow hasn’t happened first and the position remains open across time. This is supposed to be illegal but other than a few hand-slaps in the futures markets for physical commodities I’m not aware of any criminal prosecution for doing it.

    And let’s be clear here: This practice is counterfeiting.

    Come clean and be honest OR SHUT THE FUCK UP!

  4. Very well said! It’s frustrating trying to explain the irony of (b) WSB Collusion. And especially when it’s “weaponized gamma” (ie weaponized WMDs) that is the primary weapon.

    Elon Musk is the primary and sole beneficiary of WSB’s weaponized gamma since Jan 2020… and seems to be asking for more and villainizing Robinhood founders?! The man has no shame, we know that. In addition, he’s terribly reckless and will end up in prison soon enough.

    Finally, the reason SEC FINALLY limped in with a memo Friday at the US market open (imo), is to explicitly warn WSB against continuing this behavior. And primarily from weaponizing PUT gamma, when that bright ideas pops into their collective recklessly criminal “mind”.

    1. Very well said!? Citadel, Melvin, Robinhood are all incestuously linked and are part of a con by so-called market makers to game the game. Sure some registered reps who got hip to the numbers of their racket found a way to squeeze their COMPLETELY ILLEGAL CON. What this proves is the system is rigged and the only way to fight fire is with fire. If you sell something without locating it first you are counterfeiting because you are now representing that there are 110 shares in the marketplace but the company never authorized the other 10. You thus are in fact diluting every one of the existing and real shares by 10% and pocketing the money from those sales. In short you are stealing by partially destroying the value of everyone else’s holdings in that stock.

      Counterfeiting is a criminal offense — always and everywhere.

      So now you have some folks who have discerned that in fact there is more than 100% of the public float out short. This cannot happen through lawful trading activity, but it leads to an interesting conundrum: If you drive the price up you force those who committed that offense to cover their bets and there aren’t enough shares to do it. Oh, someone will eventually fork up their shares at ever-increasing prices to unwind the fraud but in the process the people who shorted naked get a telephone pole up their ass in terms of losses.

      Everyone who defends this corrupt criminal system needs to be stripped of their licenses and fined and jailed. PERIOD.

  5. Learn from the best?????????? You mean the inordinately fraudulent who, completely protected and insulated, feed at the NZIRP FED pig trough with AI and HFT machines placed right on top of exchanges, who make billions through manipulation, insider trading, spoofing and fraud and only pay relatively small fines AND NEVER GO TO PRISON?

    COHEN has been busted many times and his fines have amounted to a 10% slap on the wrist. He has the fucking BALLS to pretend to be a pillar of civil life. He owns the Mets after all. Learn from him? Sure, but first give me equal access to free fed money, Spoofing tech AI, HFT machines and immunity from ever going to prison!

    Learn from those sociopaths? Liars like you who have the stones to say that ILLEGAL NAKED SHORTING BY MARKET MAKERS USING THEIR PREFERENTIAL STATUS is just one of a few “bad strategies” and not representative of casino. FUCK YOU, you motherfucking SHILL.

    And your claim that these events are such a small percentage of the market is UNBLIEVABLE in light of the fact that cross party interest and ILLEGAL monopoly collusion is rampant. That’s why your one “bad strategy” can take down the entire financial universe YOU MORON. LTCM and Lehman? What a shameless POS you are.

      1. HOW ABOUT THAT! Yes and in the process maybe real price discovery will materialize for a short time. Until more free money bailouts are handed out to facilitate move leveraged counterparty manipulations. GOOD GOD YOU ARE WITHOUT A SHRED OF VERACITY. YOU GUYS GAME THE GAME, CREATE UNSTABLE COUNTERPARTY CODEPENDENCES AND THEN WHEN CALLED OUT AND MADE TO PAY YOU TIP THE GAME TABLE OVER AND SAY YOU NEED RESET! F U

      2. You mean they might actually be forced to net out their book and restore actual price discovery. TOO FUCKING BAD. These criminals need to suffer loses of every kind and be driven from public life and into the prisons. I listed the illegal advantages these sociopaths have accreted to themselves through capturing the system. Guys like COHEN have never been prosecuted though they have been proven to be engaged in illegalities over and over. It is so well known that Hedgies are nothing but lying cheats and thieves that a quick internet search will provide rich results about the number caught and released after paying off regulators with “fines”.

        AND YOU CANNOT HAVE MORE THAN 100% of the public float short on a stock unless market makers are abusing their status and COUNTERFEITING THE STOCK! ASS!

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