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The financial world looked on with amazement last week as members of a Reddit forum bled some of the world’s biggest hedge funds dry.
- Hedge funds and short-sellers were forced to rethink their approach after losing billions.
- Reddit day traders stunned Wall Street, shaking the wider market.
- Yet some wily firms made a killing as the GameStop battle played out.
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Wall Streets Bets forum users united to drive up the share prices of video-game store chain GameStop and others such as cinema chain AMC, “squeezing” hedge funds who had been betting against the stock.
By Friday, hedge funds and other short-sellers were nursing estimated losses of around $19 billion in 2021.
GameStop’s more than 1,500% surge sent Melvin Capital running for a bailout, and hit other hedge funds such as Point72 and D1 Capital Partners. AMC was up around 470% for the month as of Friday afternoon, causing funds further pain.
But will the chaos change the way hedge funds do business? And what impact will it have on the wider market?
Short-sellers left soul searching
Andrew Left, head of Citron Research, which was shorting GameStop, said things were going to change in the hedge fund and short-selling world as he admitted defeat last week.
Short-selling is when institutions bet that stocks will fall. They do this by borrowing those stocks and selling them. They then buy them back later at a cheaper price and then return the stocks to the original owner, pocketing a profit.
"We have to be judicious about the short book," Left said in a video posted to Twitter. "Even though we have been called 'boomers' many times over the past week, we understand the changing dynamics in the market."
"So with that we'll become more judicious when it comes to shorting stocks. Doesn't mean the industry is dead. But it just means you have to be more specific. As for longs, we have some great ideas in the future."
The revelation that thousands of Reddit users with spare cash built up during lockdown can target certain stocks will force hedge funds to be extra careful, analysts said.
Andrew Beer, managing member at Dynamic Beta Investments, an investment firm that follows some hedge-fund tactics, told Insider that the dynamic of a "mob attack" was a new minefield.
"Hedge funds will be much more cautious about crowded shorts. The prospect of losing 500% in a few weeks changes the calculus."
Yet he says hedge funds are falling prey to some of the tactics they have long followed. "Some hedge funds routinely prey on weak-handed investors."
Beer says the difference is that it used to be hard to tell who was weak or exposed. But today it's at the click of a button.
"The remarkable thing is how sophisticated many supposedly unsophisticated investors are. A few years ago, who would have expected a Reddit chat about a 'gamma squeeze'?"
Citron Research
GameStop shockwaves vibrate through stock markets
Global stock markets stumbled last week as all eyes turned to GameStop and Reddit, with the S&P 500 down around 3% for the week by Friday afternoon.
Stocks were also dragged down by short-term worries about slowing economies and arguments over the rollout of vaccines.
But many analysts said the GameStop phenomenon had knocked confidence and caused seasoned investors to rethink their understanding of markets.
Mike Wilson, chief US equity strategist at Morgan Stanley, told CNBC on Wednesday there had been a "change in the market structure."
He said: "A lot of these heavily shorted stocks [are] running up - interesting moves that are creating some pain for certain investors - and that always leads to some de-grossing, and we're seeing that now."
As part of the "de-grossing," funds slashed short positions but also sold stocks to cover losses.
Edward Moya, senior market analyst at currency firm Oanda, said in a note: "A shift in drivers on Wall Street is triggering a strong red wave of risk aversion across the board. Wall Street watched in awe as companies with terrible fundamentals saw relentless option buying by retail investors take advantage of a structural weakness in markets."
Wall Street's 'smart operators' reap rewards from GameStop chaos
However, not all of the mysterious entity known as Wall Street suffered during the GameStop saga. When any shares skyrocket, there are people on the Street who make lots of money.
For example, The Financial Times reported that Silver Lake Group, a major creditor of AMC, had reaped big rewards from the stock's surge.
Trading platforms and companies involved in the stock trades themselves have also benefited from a huge rise in activity.
Peter Garnry, head of equity strategy at Saxo Bank, said in a note: "The irony of all of this is that while many hedge funds are losing out, the smart operators on Wall Street, the market-makers, will reap a huge payday from all this activity."
Garnry's colleague, Saxo market strategist Eleanor Creagh, said 2021 was still set to be a strong year for markets as economies recover.
"[The]deleveraging process undertaken by hedge funds has not changed this regime. Yes, there is a great deal of speculation and many signs of excess, [but] we prefer to remain cautiously long."
"Cautiously long" looks set to be the new watchword for markets.