A Reddit army descends on speculative funds chained by risk models

Photographer: Tiffany Hagler-Geard / Bloomberg

An infernal week for hedge funds will be remembered for how long damage to Reddit traders caused by the pursuit of one of the shortest-running hands on the US $ 43 trillion stock market.

But that’s exactly why institutional professionals were forced to reduce its market exposures at the fastest pace since the March pandemic downturn?

One of the reasons is that their risk models told them.

As a retail cash flow sent stocks like GameStop Corp. and AMC Entertainment Holdings Inc. Growing, trading signals that guide how smart money is investing have turned red.

Known as Value at Risk, this gross value, but widely used, showed how vulnerable the short-term capital crowd was to losses based on historical price movements.

As day traders struggled with Wall Street, volatility doubled in 50 companies on Russell 3000 last week. At the same time, the shortest shares of hedge funds have gathered so much that they have exceeded their preferred lengths to a rare degree so far.

With institutional clients to worry about, professionals are appropriately reducing overall positions – while retail investors, who are free from such constraints, charge.

“When risk patterns become steady, you do well,” said Benn Dunn, who helps these managers monitor risk as president of Alpha Theory. Counselors. “Those who hold hedge funds for a long time must escape to reduce exposures – to align their risk.”

According to Morgan Stanley’s main brokerage, the decline in hedge fund exposure last Wednesday was historic, according to a general rule for a normal distribution of statistics.

At 11 standard deviations from the 2010 data average, this reduction in leverage has been the fastest since the pandemic began in March – when there was the largest movement in the last decade.

Value at risk, initiated by JPMorgan Chase & Co. In the 1990s, he tried to find out how much a fund could lose in the vast majority of cases: such as a maximum of $ 50 million a day, 95% of the time. While a person may be free to bear the risk of a large reduction, hedge funds that serve institutional customers, such as pensions, are generally linked to a game plan that limits extreme excesses.

Last week’s challenge for smart money was that reliable trading patterns were broken. Suppose a stock picker is short GameStop and long Peloton Interactive Inc. On most days, when both move in the same direction, one is a cover for the other. However, the former increased while the latter decreased – a negative and costly co-movement.

“If you are shorter and have something else and the correlation decreases, that creates your risk,” said Melissa Brown, head of global applied research at Qontigo, which provides tools for risk analysis.

On Wednesday, an exchange-traded fund that pursues hedge funds (GVIP) moved seven standard deviations from the average against a Goldman Sachs Group Inc. basket. of Russell 3000 shares with the highest short interest rate. Based on 250-day data, they are outside the statistical norm.

Of course, this is based on a normal distribution of data, which is not known, especially in complex modern markets. But it provides a simplified illustration of how the retail crowd has caused unprecedented volatility in the institutional cohort.

There are several interrelated factors of degreasing and the dust has not yet been established, as the retail crew is reloading the shortest names. Beyond those forced to reduce positions, as higher volatility increases VaR, customer redemptions and margin calls could also have put pressure.

But in a nutshell, the frenzy of the week could be another sign of a worrying trend in financial markets: statistical movements are less likely to occur more often, something known as fatter tails.

“We’ve seen the sale in all sorts of places,” Dunn said Friday. “You see things on the market that don’t make sense.”

– With the assistance of Lu Wang and Sam Potter