A Reddit army descends on hedge funds chained by risk models

Photographer: Tiffany Hagler-Geard / Bloomberg

A hell of a week for hedge funds will be remembered for how much Reddit traders damaged as a result of chasing a handful of names in the US $ 43 trillion US stock market.

But just why were the institutional benefits forced to do so reducing their market exposure at the fastest rate since March’s pandemic?

One reason is that their risk models told them.

Since stocks like GameStop Corp. and AMC Entertainment Holdings Inc. a flood, the trading signals led to how the smart money investment flashed red.

Known as Value on Risk, this rude but widely used measure, showed how vulnerable the stock-long-short crowd was to losses due to historical price movements.

While day traders fought Wall Street, volatility doubled last week in 50 companies on the Russell 3000. At the same time, the stock market funds’ shortest stocks have risen so sharply that they have outperformed their favorite extensions to an extent rarely seen before.

With institutional clients to worry about, the professionals cut the positions properly – while retail investors, who are free from such restrictions, claim it.

“If the risk models fail, you have to hide,” said Benn Dunn, who helps these executives monitor risks as president of Alpha Theory. Advisors. “What keeps the hedge funds going is to get rid of them to reduce their exposure – to align their risk.”

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

Against 11 standard deviations from the average data going back to 2010, this reduction was the fastest since the start of the pandemic in March – when the biggest move in a decade took place.

A risk value, developed in the 1990s by JPMorgan Chase & Co. started, trying to figure out the most that a fund can lose in the vast majority of cases: such as a maximum of $ 50 million a day, 95% of the time. Although an individual is free to reduce the risk of a large withdrawal, hedge funds that serve institutional clients such as pensions are usually bound by a game plan that limits excessive excess.

The challenge last week for the smart money was that reliable trading patterns broke. Suppose a stock voter is short GameStop and long Peloton Interactive Inc. On most days, when both are moving in the same direction, the one is a fence for the other. Yet the former rose while the latter fell – a negative and expensive co-movement.

“If you are short and want something else, and the correlation drops, then it increases your risk,” said Melissa Brown, head of applied research at Qontigo.

An exchange-traded hedge fund darlings fundraiser (GVIP) has shifted seven standard deviations from the average to a Goldman Sachs Group Inc. basket of Russell 3000 stocks with the highest short-term interest rates. Based on data from 250 days, it falls outside the statistical norm.

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

There are several interconnected drivers for debt reduction, and the dust has yet to settle as the retail staff is taxed anew in the shortest names. Except for those forced to cut positions because higher volatility drives up VaR, customer redemptions and margin calls may also have put pressure.

But zoomed out, the madness of the week could be another sign of a worrying trend in the financial markets: the statistically most likely movements occur regularly, something known as greasy tail.

“I’ve sold in different places,” Dunn said Friday. “You see things in the market that don’t make sense.”

– With the help of Lu Wang and Sam Potter