An army of Reddit descends from hedge funds chained by risk models

Photographer: Tiffany Hagler-Geard / Bloomberg

A hellish amount will be remembered for hedge funds hurting Reddit traders caused by chasing a handful of the shortest names on the US $ 43 trillion stock market.

But why were institutional professionals forced? reduce the size of their market exposures at the fastest pace since the March pandemic defeat?

One reason is that their risk models indicated it to them.

When a flood of retail money sent stocks like GameStop Corp. and AMC Entertainment Holdings Inc., trading signals that guide how smart money investing flashed red.

Known as Value at Risk, this crude but widely used metric, showed the vulnerability of the short equity crowd to losses based on historical price movements.

As day traders struggled against Wall Street, volatility doubled in 50 Russell 3000 companies last week. At the same time, shorter hedge fund shares were so concentrated that they outperformed their long favorites to a degree that had rarely been seen before.

With institutional clients to worry about, professionals duly reduce overall positions, while retail investors, who do not have these restrictions, charge.

“When risk models break down, you break down,” said Benn Dunn, who helps these managers control risk as president of Alpha Theory Advisors. “What hedge funds hold for a long time must be disposed of to reduce their exposures, to align their risk.”

According to Morgan Stanley chief broker, the drop in exposure to hedge funds last Wednesday was historic, according to a general rule for a normal distribution of statistical data.

With 11 standard deviations far from the average of data dating back to 2010, this deleveraging was the fastest since the pandemic broke out in March, when the largest movement occurred in a decade.

Value at risk, initiated by JPMorgan Chase & Co. in the 1990s, he tries to figure out how much a fund can lose in the vast majority of cases – at most $ 50 million a day, 95% of the time. While a person may be free to stomach the risk of a large reduction, hedge funds that serve institutional clients, such as pensions, are generally bound by a game plan that curbs extreme excesses.

Last week, the challenge of smart money was to break reliable business patterns. Suppose a stock picker is GameStop short and long Peloton Interactive Inc. Most days, when they both move in the same direction, one is a cover of the other. However, the former rose while the latter plummeted: a negative and costly move.

“If you have little and you have something more, and the correlation decreases, that actually increases your risk,” said Melissa Brown, head of global applied research at Qontigo, which provides tools for analyzing risk.

On Wednesday, a fund traded with hedge fund tracking stock exchanges (GVIP) moved seven standard deviations from the average relative to a Russell 3000 stock basket from Goldman Sachs Group Inc. Based on 250-day data, which is outside the statistical standard.

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

There are multiple factors related to deleveraging and the dust has not yet settled, as the retail crew is charging the shorter names again. Beyond those forced to cut positions, as higher volatility increases VaR, it is possible that customer amortizations and margin calls have also exerted pressure.

But narrowly, the frenzy of the week could be another sign of a worrying trend in financial markets: statistically less likely movements are occurring more frequently, something known as thicker tails.

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

– With the assistance of Lu Wang and Sam Potter