No significant short squeeze contagion in Asia

In late January, there was an extremely concerning development that captured the attention of people who wouldn’t normally be interested in financial markets. It was portrayed as a Main Street versus Wall Street battle with retail investors scoring a massive victory over hedge funds.

I’m referring of course to the short squeeze in Game Stop and other stocks which had a high level of short interest and which were deemed to be suitable targets by the Redditors. It created severe liquidity driven price distortions which will ultimately unwind – and result in significant losses for many retail investors – but the harsh reality is it is not possible to maintain short positions in the face of such an onslaught. Many hedge funds were forced to cover their positions and lock in considerable losses. Melvin Capital was down more than 50% for the month.

The target list of companies spread to Europe but the impact in Asia was limited. In Australia, Hong Kong and Japan some companies with a relatively high level of short interest outperformed in late January but this was probably driven more by hedge funds partially covering their shorts than any sustained retail buying pressure.

Nevertheless, the short squeeze was a powerful reminder of the dangers of shorting stocks.

Fortunately, the Fund’s investment process mitigates this risk by:

• identifying crowded shorts via quant factors based on short interest data,

• having a highly diversified portfolio of short positions,

• supplementing short stock positions with short index futures positions.

These safeguards are based on many years of experience managing short portfolios. I’ve witnessed numerous liquidity driven price distortions, including the Great Quant Unwind in August 2007 and the frenzied buying of Volkswagen shares in 2008 which briefly made it the most valuable company in the world.

Although co-ordinated attacks by retail investors are a new development, short squeezes aren’t and any robust long-short investment process should include safeguards to protect against this risk.