Why a 'garbage rally' powered by junk stocks could explain quant hedge funds' no good, very bad summer

Business Insider

25-07-2025

As the fundamental investing world marvels at another potential bubble made up of meme stocks and retail traders, quant hedge funds are trying to solve a much more complex problem.
The smartest people at the smart money firms have been on a weekslong losing streak starting at the beginning of June, with firms like Qube, Two Sigma, and Point72's Cubist suffering losses over that time. Wednesday was another rough day of trading for many funds as the average quant lost 0.8%, according to Goldman Sachs.
The bank's prime brokerage unit said July was on track to be the worst month in five years and pointed to similar factors as it did earlier in the week: A momentum sell-off, crowded trades, and high volatility in certain stocks.
Business Insider previously reported that quant firms have been trying to pinpoint the cause of the steady-drip losses that have eroded a hot start to the year in systematic trading.
Goldman isn't the only firm that's begun to wrap its head around what's happening. Computer-run managers have come up with theses, found parallels to past markets, and are even planning for a quick rebound.
A belief taking hold is that broader market calamity is unlikely to spread, as the sources of pain aren't fundamental market weakness or a lurking economic maelstrom, but rather the opposite: a surprisingly strong economy that has flooded the markets — and questionable stocks — with liquidity that happened to catch quants wrong-footed.
Dark Forest Technologies, a quant fund run by former Bridgewater researcher Jacob Kline, wrote in a Friday note to investors that the current scenario is "not at all like 2007," when forced deleveraging inflicted rapid losses across the systematic space. He said this summer's swoon is a byproduct of "what we politely call a 'garbage rally.'"
He theorizes that the resurgence in heavily shorted junk stocks in recent weeks has forced some smaller quant firms to sell their positions, adding to the pain for everyone still holding on.
"It's a bad month but not a crisis; the drivers are atypical but not surprising," the note reads.
It's not Sydney Sweeney and the memestock crowd
Don't give too much credit to Sydney Sweeney and the memestock crowd. They were late to the ball game.
One executive at a multimanager fund involved in quant strategies said some large funds started noticing losses before June. Weeks before Kohl's and American Eagle became retail darlings, some micro-cap stocks and thinly traded Chinese names "had been running for three weeks doing silly things."
"There's no underlying malady. No COVID. No great financial crisis," the multimanager exec said.
He ascribes blame largely to a broader surge in market liquidity and risk appetite, a result of positive macroeconomic developments that began burbling months ago.
A "peculiar set of circumstances" preceded the quant bleeding, according to Kline. The broader stock market rally heading into June was largely driven by retail and systematic trend-following. Hedge funds had relatively low net exposure — but they had been hedging the quality stocks by shorting weak ones, which was profitable. The market reached all-time highs in June, and with prices so rich, hedge funds stopped adding to those high-quality stocks but also stopped betting against the weak ones.
Removing their short positions boosted "garbage" stocks, which attracted the attention of retail traders and meme stock enthusiasts, driving those positions up further.
Because quants, in simplistic terms, use their mathematical firepower to "sort good from bad," as Kline put it, this rally in low-quality companies set many of them up for pain.
"Quants are generally going to be on the other side of that kind of arbitrary move," Kline said.
Strategies that jump on short-term trends "may be exacerbating" the surge, said Antoine Haddad, founder of $1 billion Bainbridge Partners, a multistrategy hedge fund with quant portfolio managers. This includes "AI-driven algos too," he said.
The big-picture driver of this frenzied trading is the strong macroeconomic backdrop — low inflation, muted tariff impact, lack of rate hikes from the Federal Reserve — which has attracted more money into the market. During Covid and the original memestock craze four years ago, the market was awash in liquidity, and money gravitated to odd places, including seemingly worthless stocks — not to mention NFTs, cryptocurrencies, and SPACs.
What's happening in 2025 is an echo, similar but far less intense.
Another wrinkle and outgrowth of the increasing liquidity and risk appetite is the thaw in equity capital markets, which "have lit up like a Christmas tree," the multimanager exec said.
While capital raising was dead much of this year, companies in June began raising money again through initial public offerings, follow-on raises, and convertible bonds, all of which "accelerated towards the end of the quarter, as global issuers and investors gained confidence amid a market rebound," according to Morgan Stanley's mid-July earnings call.
This allows companies, "garbage" or otherwise, to improve their prospects by injecting their coffers at attractive valuations, potentially boosting their stock price as well.
While many hedge funds closely monitor such activity, it's not traditionally the bailiwick of quants.
"Quants don't sit in that business and they don't see that flow," the multimanager exec said.
All eyes on the industry's largest quant funds
Understanding the source of the quant carnage is one question. Identifying when the pain will abate is equally important.
One trader who works at one of the industry's largest quant funds told BI that the actions of the biggest firms will be the most significant factor over the next week. If these funds are forced to sell, then there could be serious pain that could impact everyone from Fidelity mutual funds to Robinhood retail traders.
"Some small players don't have a choice but to capitulate," the multimanager exec said, adding that the larger firms know that if a major peer cuts its exposure, "then it becomes a bigger contagion and gets out of hand."
This hasn't happened yet, and some are betting that the bigger players will just sit tight.
The size of the funds, the pain tolerance of their executives, and the trust they have in their models is where the quant heavyweights have the ability to shine. They either have investor capital locked up for years or a giant horde of internal money — meaning they can withstand losses for longer, especially if they anticipate a bounceback.
Dark Forest compared the situation to the end of 2023, when some smaller quants were stung by the Federal Reserve's signalling that lower rates may be coming. This increase of liquidity in the stock market caused a similar surge in stocks that quants were either short or not invested in. Those who "pulled back missed out badly," while funds that held firm saw substantial gains in the following months.
"Like 2023, the losses are big enough to where they are inducing the weaker hands to delever, which is exacerbating the losses this week," the note reads. But this time around, the "strong hands" will let their models continue because "the ARKKs of the world are unlikely to keep outperforming the market by 10% a month," Kline said, referring to the innovation-focused ETF managed by Ark Investment Management.
"We think strong hands should be levering up into this headwind," the note concluded.
Another executive of a small quant fund said they planned to ride out the "froth in sexy sectors."
"We are not going to suddenly switch our models over this," he said. "It had been a great year before the summer. Those conditions can come back."
The multimanager exec believes the worst is over. It can take time for markets to recalibrate the junk stocks, but "now that everyone is writing about it, we're probably done."