31 January 2021

Lost in communication: Fixing the GameStop standoff

The ongoing David versus Goliath battle between retail investors and hedge funds might have been avoided, saving both groups billions of US dollars

Will Wall Street be the same again, after retail investors challenged the viability of hedge funds within the financial markets ecosystem? Perhaps not.

By Holly Huang

Of the many fallouts stemming from the current economic crisis, swathes of competent professionals working from home — or worse, unemployed — is among the most notable.

The sheer repetitiveness and dare I say boredom of living and working in the same location seems to have unearthed an itch for risk-taking. Online dating and a few adult websites have been noteworthy winners, it appears.

Day trading has also benefitted. Enormously, in fact.

In many cases, aggrieved at the bad hand of life’s cards they have been dealt, netizens have taken to the stock market to vent their frustrations — while probably telling their bosses and spouses (in many cases both) that they’re merely shopping for groceries, or checking out the next overseas family holiday once the pandemic retracts. A potential recipe for disaster (pun intended).

One word epitomises today’s scenario: GameStop. The once unloved ‘bricks and mortar’ video game retailer is at the centre of an almighty grudge match between average Joe retail investors and Wall Street hedge funds — a truly ‘David versus Goliath’ tussle.

Little is known about what genuinely prompted the standoff, but speculation abounds. The Davids have been commingling virtually on the WallStreetBets community Reddit page since 2012. However, stock buying at GameStop surged with the appointment of chewy.com co-founder Ryan Cohen to the firm’s board on January 11. From seemingly nothing, Cohen built the online pet supplies retailer into a multi-billion dollar business within a mere few years, eventually exiting for US$43 billion in 2017. GameStop’s bosses hope he’ll do the same for their company.

Stocks at GameStop initially rallied 13%. The surge didn’t stop there. Two days later it rose again by 57%, then 27% and so forth. By close of trading on the last day of January, the stock posted a year-to-date rise of 1,587%. This time last year a single share at GameStop cost US$4. At the time of writing, it’s worth US$325. Don’t assume that this will last, though.

‘Us and them’

At the heart of the GameStop saga are seemingly disgruntled day traders out to ruin hedge funds that they see as ‘elitists’ profiting off the losses experienced by the common man — a classic and very bitter ‘us and them’ scenario. The hedge funds in question have placed big bets on the stock price of GameStop crashing, an investment strategy known as short selling. If its share price plummets — and typically it’s a matter of ‘when’ rather than ‘if’ the moment a hedge fund places such a bet on a particular stock — bankruptcy commonly follows, with job losses in the several of thousands.

Retail investor interest in GameStop has nothing to do with the strength of its business, stock analysts universally concur. Quite the contrary, stores selling computer discs is something more akin to the 1990s than the cloud computing era of the 2020s. GameStop is one of many struggling companies to receive support from the Reddit crowd. Others include AMC (owner of Odeon Cinemas), Blackberry, and Macey’s — collectively referred to as “90s nostalgia stocks”. Although nostalgia has very little to do with the real reason for their backing.

Widespread loathing of hedge funds is clearly the driver behind the saga. To meet their own financial pressures, hedge funds are having to cover their losing bids to the tune of several billion dollars, much to the delight of the Davids. Moreover, what was once a predominantly American movement has since gone global. Retail investors from Asia to South America have joined the GameStop cause.

Prince of thieves

Last week, the stand-off was further exacerbated by the announcement made by commission-free stock trading app Robinhood that it was suspending trading of GameStop shares. Retail investors were spooked — a sentiment hedge fund managers had prayed for. But instead of selling, investors held their positions, inspired by rallying cries on Reddit along the lines of “we’ve come this far, let’s not give up now!”

Robinhood’s brand promise to democratise investing majorly backfired, with one Reddit user filing a class-action lawsuit, claiming the app rigged the market against its customers and inferring it to be a modern-day prince of thieves. US Congresswoman Alexandria Ocasio-Cortez weighed in, calling the app’s decision to suspend trading “unacceptable”. And US Senator Elizabeth Warren, a prominent voice in favour of tougher financial regulation, said the saga warrants wider investigation, pointing to fault on both sides of the battle.

Robinhood soon relented, saying it would limit buys. It also raised US$1 billion in cash from private investors, claiming it was short of the money needed to facilitate the extraordinarily high number of trades. The irony.

The app wasn’t the only day trading platform to get cold feet. In the early hours of Sunday morning, UK-based trading platform IG Group announced that it was suspending all new trades relating to GameStop and AMC.

Just how the saga will play out in future is anyone’s guess. Though ultimately, we can expect Goliath to triumph, as an entrepreneur and independent operator, a part of me will always root for the Davids of this world.

Avoiding the unavoidable

Looking back over the whole saga, one can’t help but feel it could have been in part avoided, and that some of the responsibility must lie at the feet of the financial community.

Hedge funds, particularly those from Wall Street, are infamously opaque about how they operate and why they take such bets. This makes them easy targets for disgruntled day traders. The secret is in the name ‘hedge’, as in ‘hedging your bets’, but generally little effort is made to explain to the general public why such positions are taken out, and what purpose they serve within a portfolio in terms of avoiding downside risks.

It also doesn’t help when the history of hedge fund executives is somewhat chequered. Steve Cohen, founder of hedge fund Point72, one of the short sellers of GameStop’s stock, previously pleaded guilty to insider trading charges filed against his former firm SAC Capital, which subsequently shut down.

Short sellers are notoriously secretive. On one hand, this is understandable, as they don’t want their rivals knowing their trade secrets. Yet on the other hand, there is an important role for hedge funds in the financial markets, which rarely gets aired. As Warren Buffet once explained, “The more shorts, the better, because they have to buy the stock later on.” The legendary investor added that short sellers are necessary correctives who “sniff out” wrongdoing or problematic companies in the market. (CNBC’s Sarah O’Brien gives a great explanation of what short selling entails here.)

It’s worth noting that pension funds and insurance policies heavily rely on a wide variety of hedge funds to grow their investments, as well as protect against financial losses.

As a communications professional who has been servicing the funds industry 15 years or so, my personal observation of the perceived elitism stems from firms being reticent about discussing strategies and operational matters in public. But by being so, they risk investor and public backlash caused by unwanted misinformation — a magnified issue in current times — and an array of misunderstandings.

Based on the events of the past month, this needs to change. Transparency and accountability cut both ways.

Had short sellers and the wider hedge fund community been more transparent about their businesses, the above events might not have happened — and the big losses soon to be incurred by the WallStreetBets community might have been avoided.

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