The Short and Long of Recent Volatility

Market Event Overview: Late January 2021 saw volatile, unexpected price surges in heavily shorted stocks, driven by a convergence of retail trading activity and hedge fund positioning.

• Prime brokerage clients increased long exposure significantly faster than short exposure starting in October 2020.
• The long-short ratio for long-short community clients hit an all-time high at the end of 2020.
• In early January, clients covered nearly 5% of their U.S. short book without corresponding long selling or de-risking.
• This asymmetry left long exposure stretched, setting the stage for the volatility.

Performance Metrics and Dynamics:

• As of January 22, long-short funds recorded a net positive 50 basis points alpha (driven by a positive 50 bps beta offsetting 250 bps negative alpha).
• Asset-weighted performance for long-short funds declined by 5.9% for the month of January.
• Losses were primarily concentrated on the short side (estimated 5.5% loss) versus a modest 0.4% loss on the long side.
• Stocks with the highest short float in the short basket gained 42% during the month.
• On January 27, the worst single day of the period, funds were down 7% for the month, triggering a sell-off.
• January 27 saw the largest notional selling volume observed by Goldman Sachs Prime Brokerage since 2008.
• De-risking events occurred globally, with the U.S. account for the majority of the volume, though Europe and Asia also saw activity.

Role of Leverage and Strategy:

• Kevin Kelly (Goldman Sachs) determined that leverage did not play a material role in the volatility.
• U.S. Long-Short funds typically operate with gross exposure to equity (NAV) below 200%.
• The primary driver of distress was the performance degradation of concentrated short positions rather than a forced leverage unwind.

Short Squeeze Mechanics and Retail Impact:

• Owen Lamont (Wellington Management) characterized the event as a "flash mob short squeeze" distinct from historical cases like Volkswagen (2008) or the Hunt Brothers (silver, 1980).
• Unlike historical corners where a few large players controlled supply, this event involved a large coordination of small retail traders via social media.
• Retail trading's volume share in total equity market volume has likely doubled over the past couple of years.
• Options market activity by retail investors has "exploded," facilitating a "crowdsourced gamma squeeze."
  • Retail investors buying options forces dealers to hedge by purchasing underlying shares, magnifying price impact.

Future Outlook and Market Fragility:

• Kevin Kelly notes that while the specific confluence of events may be less likely to repeat, underlying dynamics remain; however, hedge funds have repositioned to be more nimble.
• The "GSMO short basket" constituents have seen short covering of up to 65% year-to-date on a unit basis as of the interview.
• Kelly confirmed that execution, financing, and clearing functions worked properly even during record volume days.
• Lamont argues that prices in select names are becoming increasingly disconnected from fundamental value and driven by sentiment.
• Lamont warns of a "self-reinforcing cycle" where volatility begets illiquidity, suggesting more volatile episodes and flash crashes are likely ahead in illiquid or specific market corners.
• Arthur Levitt draws parallels between the January 2021 volatility and the Internet bubble, citing a similar "divorce of pricing from fundamental research."

Regulatory Implications and Future Oversight:

• Levitt suggests record-low interest rates have driven savers to "chase yield" in risky assets, contributing to the culture of extreme risk-taking.
• Levitt argues that retail trading platforms often mislead investors by claiming "free trades," when in reality brokers profit from payment for order flow (PFOF), potentially routing trades to suboptimal venues.
• Levitt advocates for greater transparency in market "plumbing" and for platforms to act in the "best interest" of customers.
• Both Levitt and Lamont defend short selling as a stabilizing force that introduces negative information into prices and improves liquidity.
  • Lamont cites Milton Friedman's view that speculation is stabilizing when driven by profit motives, whereas non-profit speculation (gambling/protest) is destabilizing.
• Levitt does not foresee new specific regulations to prevent short squeezes, noting such episodes recur, but anticipates SEC Chair Gary Gensler will rigorously review existing rules for modern relevance.
• Levitt emphasizes that the SEC's primary role should be educating the public on long-term investment risks rather than relying solely on rule changes.
• Levitt predicts retail trading volume may level off as economic normalcy returns but will likely outlast the next market correction.