The emergence of 'guerilla’ retail investors has taken capital markets and regulators by surprise, creating substantial losses for hedge funds that had to cover their short positions on otherwise unloved stocks like Gamestop. Should pension funds see this as just another blip, or a threat to the functioning of capital markets?  

 

When retail investors sitting on lockdown-accumulated cash used apps like Robinhood to buy the shares of a Texan video games retailer en masse and thus undermined the short bets of hedge funds like Melvin Capital, the capital market establishment was in shock. 

 

The retail buyers had colluded to buy the stock on a chat subforum by Reddit and drove the Gamestop share price to dizzying heights before Robinhood decided to suspend trading. The investors then set their sights on AMC Entertainment and even silver, which also saw a squeeze.  

 

 

The events in late January were so concerning to some that the key actors involved – including Robinhood CEO Vlad Tenev and Ken Griffin, the founder of hedge fund Citadel – had to testify before US Congress. So how worried UK should pension funds be about this phenomenon? 

 

Not at all, seems to be the view of Alasdair Gill, head of investments at XPS Pensions Group in Scotland, who says that defined benefit pension funds are moving away from equities in any case. “Any equities they do have would be well diversified, so having these little blips won’t have a big impact,” he believes. Even in defined contribution pots, diversification would mean that this is a minor issue, he argues; and the areas where pension funds use derivatives and short positions, like inflation or interest rates, are not accessible to retail investors. 

 

But the GameStop episode has shown that hedge funds are vulnerable to this kind of shareholder action, and could even spell the end for some, raising questions about redemptions where pension funds are invested with them. 

 

 

For Gill, pension funds should not be invested in hedge funds at all, however. He argues that they are expensive and have not added any value for long-term investors, whether DB or DC, since the financial crisis of 2008 – when they fell out of favour with pension funds for redemption problems. “They benefit the hedge fund [managers] themselves before they benefit the investors,” Gill says.  

 

Most of his clients therefore would not even have exposure to funds of funds. While there are certain fiduciary managers that maintain an exposure to hedge fund strategies, “it's increasingly difficult to justify”, he says. 

 

Those in favour of hedge funds often argue that hedge funds are not there to look good in a long-term bull market but to protect against downside risk, but in this long-term bull market, for pension funds “it’s not really been worth the wait”, says Gill. 

 

Whether the bull run will end soon – and offer hedgies a chance to shine – is currently anyone’s guess. For Gill, the GameStop frenzy is symptomatic of a late-stage bull market in which retail investors believe equities can only ever go up, but whether the rosy outlook priced in by markets is overly optimistic only time will tell. 

 

Exposure to a hedge fund implicated in the events could lead to redemption issues in theory, but “I suspect few UK pension schemes invest in the hedge funds investing in GameStop”, says Simon Cohen, head of investments at consulting firm Spence & Partners. 

 

Smaller schemes in particular do not invest in a single hedge fund or any hedge fund at all; at most they would be invested in a fund of funds, and so any impact from a spike like GameStop’s would be very limited, he says. 

 

For Cohen, the events of late January merely serve to reinforce the view that pension schemes should not invest in high risk assets. 

 

 

With the short-term impact of GameStop being the unwinding of positions, “it’s likely that hedge funds will be more prudent in this space going forward”, finds Joe McDonnell, head of portfolio solutions, Neuberger Berman, as short-selling transparency can create issues for shorts, especially in smaller caps. 

 

Hedge fund strategies are much broader than this, however and “investors would be wise to combine different strategies and managers” while keeping overall correlation to equity low, he notes. Managed account platforms can help to improve transparency and risk management, he adds, as it’s more likely that outsized single stocks risk would be more ‘red-flagged'. 

 

So is the issue dealt with for pension funds by avoiding hedge funds or diversifying them, and riding out short-lived volatility? Not everyone is convinced. 

 

Tom Kehoe, global head of research and communications at the Alternative Investment Management Association, says GameStop, AMC & Co are more about the impact to markets than what might happen to a hedge fund or any other fund. 

 

“Situations like what occurred last month do potentially threaten the existence of fair, orderly and efficient markets – an important public good for all companies and investors. Hedge funds are an integral part to this.” 

AIMA's chief executive Jack Inglis has argued that short-sellers fulfil a vital function in capitalism, stressing that the practice was tightly regulated, with rules specific to short selling, as well as market abuse rules to fight market manipulation.

"Regardless of one’s views of hedge funds, what everybody should be focusing on is the fair, orderly and efficient functioning of markets. That is vital for all investors, big and small," he told AIMA members.

 
He noted that "finger wagging at short selling is not new", but that AIMA and others have "shown time and again that it is useful in the efficient functioning in markets. All major regulators too have acknowledged this."