DJ GameStop Resurgence Reinforces New Reality for Hedge Funds

By Julie Steinberg in London and Juliet Chung in New York

Investors have pared back their bearish bets a full month after the GameStop frenzy took off, showing the lasting effects of the Reddit-fueled saga on funds that make money by shorting.

Firms across the hedge-fund industry unloaded short positions that gain when stock prices fall, after a handful of stocks touted on Reddit and other social media platforms surged in January. They feared other stocks might experience the same meteoric rise.

The result: U.S. stock-picking hedge funds, which bet on and against stocks, are more tilted toward bullish bets than in any other period since 2010, Morgan Stanley's prime brokerage unit said in a note this week.

Short interest relative to the shares available to trade for stocks in the broad Russell 3000 index fell to 5.6% on Feb. 22 from 7.5% on Jan. 19, according to S3 Partners, a data-analytics firm. That follows a year-long pattern of hedge funds reducing their short bets as markets soared after March.

"This is the equivalent of the hack on Sony," said Bob Sloan, managing partner of S3, referencing the 2014 hack of the Hollywood studio that brought down its email and leaked sensitive data. "Everyone has looked around and said, 'Wow, this could be me.'"

GameStop's resurgence this week -- its stock price more than doubled over the course of a few trading hours Wednesday and Thursday -- highlights the risks. As of Feb. 12, 30% of GameStop shares were shorted, down from more than 100% in January, according to Dow Jones Market Data. The stock, however, remains among the most heavily shorted on Wall Street.

To protect themselves, hedge funds have gravitated toward bets that spread out their risk, said managers and their clients. Some are following new internal rules to close out short positions before they lose too much money. Others are finding ways to take positions without having to disclose them to the market.

Short interest on U.S. exchange-traded funds has ticked up to 21.4% from 20.3% from mid January, according to the S3 data, a sign that some investors are switching out of single-name shorts into shorts on indexes instead.

Valiant Capital Management, a $2.8 billion San Francisco firm, told investors it is likely to reduce the number of companies it bets against, according to a Feb. 4 letter. And for the first time in its 13-year history, Valiant is avoiding stocks that lack near-term events that could trigger a price collapse.

The firm, which had a yearslong bet against German fintech company Wirecard AG before it imploded last year, is still committed to shorting. Valiant founder Chris Hansen wrote that the current market recalled the "waning months" of the dot-com bubble and ultimately would lead to opportunities for short sellers.

Some firms are weeding out their portfolios and avoiding crowded trades or small stocks that could get swept up in retail mania.

"We still have on shorts, but they're plain-vanilla, larger-cap stocks where short interest is not that high," said Pieter Taselaar, founder of the $900 million Lucerne Capital Management in Greenwich, Conn. His shorts include bets against Dutch payments firm Adyen NV and German e-commerce company Zalando SE, shares of which have been pandemic lockdown winners.

In Europe, where short positions over 0.5% must be disclosed publicly, more than half of the more than 1,100 short-related disclosures since Jan. 31 were reductions in such positions, according to research firm Breakout Point.

Melvin Capital Management and D1 Capital Partners, two firms hurt by losses related to GameStop and other wagers, have continued cutting their European short positions since late January, the data show.

Tiger Global Management is moving the other way: Over a stretch earlier this month it added to shorts on French train maker Alstom SA and European property company Unibail-Rodamco-Westfield SE. A Tiger Global spokesperson declined to comment.

Another lesson from GameStop is to avoid disclosing certain holdings so as to not attract attention from opposite-minded investors. One strategy is to use so-called total return swaps, in which investors pay a bank a fee to earn returns on certain securities but don't actually own those securities, eliminating the need for disclosure.

A hedge-fund manager with $2.5 billion in assets under management said he now uses total return swaps 80% of the time, up from 50% before GameStop. He avoids buying put options, which give investors the right to sell stock at a certain time and price and must be disclosed, and times his trades to minimize disclosure at quarter-end.

Melvin and Maplelane Capital LLC, which lost more than 50% and about 45% in January, respectively, said in quarterly regulatory disclosures about their U.S. stock and options positions filed last week that they had omitted information. Confidential filings with the SEC are a tool activists have long used to build positions in companies quietly.

Laurel FitzPatrick, an attorney who works with hedge funds at Ropes & Gray LLP, said clients are growing more attuned to social media. One fund manager wondered if a short might be problematic because of its catchy ticker, which could draw Redditors' attention, Ms. FitzPatrick said.

Hedge-fund manager Ricky Sandler bailed out of his bets against individual companies in January, trying to prevent losses as their stock prices rallied. By the end of the month, his $7.8 billion Eminence Capital LP had covered most of those shorts, clients said. His hedge fund lost about 11% in January.

Mr. Sandler wrote in a letter to clients earlier this year that managing the risk of shorts due to the individual-investor-driven Robinhood phenomenon could mean taking smaller losses "to avoid unacceptably large, unbounded losses."

He has started placing some bets against individual companies again in February, said a person familiar with the fund, and has gained 9% for the month through Feb. 19.

Write to Julie Steinberg at julie.steinberg@wsj.com and Juliet Chung at juliet.chung@wsj.com

(END) Dow Jones Newswires

February 26, 2021 05:30 ET (10:30 GMT)

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