Hedge funds that hunkered down after GameStop at the moment are lacking out on market positive factors

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Hedge funds are still licking their wounds after a frenzy in retailing forced the industry to reduce all exposure to stocks, resulting in underperformance in 2021.

Last month, an army of retail investors who coordinated on social media managed to get GameStop stock up 400% in just one week, creating massive shortages on a number of heavily shortened names. Hedge funds that were burned on their short positions tried to reduce overall risk and sell winners to raise money.

This set off a domino effect that resulted in the biggest week of hedge fund leverage since February 2009, according to Goldman Sachs’ Prime Brokerage Unit.

The dust hasn’t settled yet as the damage caused by so-called stupid money seems to be permanent. The 20 most popular long positions among hedge funds have outperformed the S&P 500 by an average of more than 1% year-to-date, according to RBC’s analysis of 330 hedge funds based on recent filings.

“This is partly due to the degrossing of hedge funds in January when hedge funds responded to the retail insanity that gripped the equity markets,” Lori Calvasina, director of US equity strategy at RBC, said in a note. “The impact of the January hedge fund unbundling more than offset the recovery in performance from late January to mid-February.”

Meanwhile, amateur retailers, often cursed for their lack of sophistication compared to Wall Street pros, continue to build their momentum even after most of the brief bottlenecks are cleared.

A basket of preferred retail stocks rose 18% this year, outperforming a basket of popular hedge fund longs by eight percentage points and the S&P 500 by four percentage points, according to Goldman.

This David-Goliath fight came at a particularly vulnerable time for hedge funds. Professional traders had already gotten into a major market rotation of their tech darlings and morphed into cyclical names amid an economic recovery. Growth-loving hedge funds are still underweight energy and finance, two of the biggest winners this year with rallies of 25% and 10% respectively.

Record leverage

The GameStop mania also highlighted the hedge fund community’s Achilles heel – high levels of leverage and focus. According to Goldman, hedge funds started the new year with the highest net and gross exposure.

“The January short squeeze demonstrated how the combination of leverage and overcrowding poses risk to both hedge fund returns and overall market performance,” said David Kostin, head of US equity strategy at Goldman, in a note.

Hedge fund portfolio concentration and overcrowding also remained historically high, data from Goldman showed. The five largest stocks of hedge funds – Amazon, Microsoft, Facebook, Alphabet, and Alibaba – have stayed the same for ten consecutive quarters, according to Goldman.

Still, not all hedge funds emerged from the short squeeze saga beaten, and those that dodged the bullet tend to be more cautious of risk.

Third Point’s Dan Loeb, whose hedge fund bypassed the heavy losses caused by the GameStop mania, said in a February 10 letter to investors that he’s increasingly comfortable with higher net and lower gross exposure, which means that his fund tends to have larger long positions than short positions.

Loeb also said he learned his lesson by betting against names with overly short interest.

“After some painful experience of holding positions against companies with large short-term interests, we had a preview of what can happen and reduce our losses,” he said in the letter.

– CNBC’s Michael Bloom contributed to the coverage.

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