It’s kind of amazing that the Gamestop (GME) short squeeze trade has become the biggest news story in America; judging on headlines alone, the Wallstreetbets drama has become a bigger story than the coronavirus vaccine, Biden’s presidency, or the near $2 trillion stimulus plan being prepared. In part because of the David and Goliath nature of the story and the fascinating mechanics of the story, its human drama and intoxicating life-changing events for investors big and small warrants close scrutiny.
But as narratives form around this event, it is important to not embrace one as the ultimate truth, especially if that narrative is becoming the most popular one around a very complicated and multifaceted tale.
One such narrative, which is becoming popular among Wallstreetbets itself is the idea that the GME short squeeze has a moral imperative behind it, and this trade will end the practice of short selling entirely. That is very unlikely for many reasons, the most importantly that short selling does have an important function in the market of limiting asset bubbles and providing insurance. Commentators have been ignoring the fact that shorting is often used as a way to hedge long gets on the market or on stocks–hence the term “hedge fund”. And almost all hedge funds are net long funds, with some abandoning the practice of shorting or doing it at a very small portion of total AUM in recent years.
For the hedge funds that are net long the market, the GME short squeeze will not and cannot ruin them. For those that have a GME short position, if that position is not overly aggressive, it can be mitigated easily during the runup in a variety of ways, such as buying call options, buying the stock itself, or selling puts to create a synthetic long position (these are just a few of many such strategies that could be employed). In short, the only way for a fund to be obliterated by the GME short is if, as a portion of its total portfolio, it is heavily short and either cannot or does not cover that short in a timely fashion.
Are the hedge funds targeted by Wallstreetbets in a position to do this? Outside of the funds themselves, no one really knows (and it is likely that many inside the funds, such as the lower level analysts, don’t even know, either). There is a chance that one or two funds will go bankrupt over this event, but that is quite low.
And the chance that hedge funds will end is zero. Not many funds were short GME, and some may have gone long GME in recent days.
This doesn’t mean the world of hedge funds has not changed forever. Two hedge funds that had relative obscurity (a valuable asset in high finance) are now household names. Reputations have been tarnished if not ruined in some cases, and, more crucially, the act of aggressive shorting has faced more scrutiny than ever before, both by regulators and investors such as high net worth individuals and pension funds.
For these reasons, hedge funds will never short the same way again, even if they will continue shorting stocks.