The story of how retail traders (those that trade stocks for themselves at home) outsmarted highly sophisticated institutional hedge funds via the social media platform Reddit has gained a lot of interest in recent weeks. How does this impact pension trustees and the future of financial markets?
This extraordinary story focuses on a troubled bricks-and-mortar US videogame retailer called GameStop. As with many retailers in recent times, it was not able to cope with the rapid speed that customers switched to online shopping - accelerated by Covid-19 – and thus the company’s sales and stock price were down.
Many hedge funds bet that the share price of GameStop would further decline via short selling. To briefly summarise short selling, Firm A borrows a stock and sells to Firm B hoping to buy it back at a lower price. However, Firm B can also lend the same stock out. This can lead to more stocks being sold short than actually exist. This is the scenario that savvy retail investors identified in GameStop and worked to their advantage.
Short selling is very risky; unlike buying a stock where the most money you can lose is the price you paid for it, short selling losses can be unlimited. If the share price of GameStop increased, the firms that shorted (borrowed) it would need to buy it back, further causing the share price to increase. This snowball effect is known as a short squeeze. It caused the GameStop stock price to increase 1730% in a matter of weeks and resulted in hedge funds posting large losses. The trading frenzy affected many other companies and caused a 60% spike in implied volatility.
A short squeeze is common; however, GameStop has gained enormous media attention as it was particularly large and viewed as an underdog story. Novice retail investors won against clever hedge funds: one prominent hedge fund, Melvin Capital Management, reported a 53% loss in January 2021 due to the short squeeze. Retail investors have never been able to impact the markets to such an extent before.
How will this impact trustees?
Most pension schemes have a highly diversified equity exposure and would not be impacted by small individual stocks such as GameStop. However, schemes that invest in certain types of hedge funds, or through a fiduciary manager, will likely have been impacted. As pension schemes are long-term investors, short-term volatility does not cause a material impact and trustees should remember that over time asset values will be restored to their fundamental value.
Future of financial markets
As of 1 February 2021, the trading frenzy is still continuing with silver being the next target – it increased by 10% in one day to reach a five-month high. However, silver is a much larger market than GameStop and it is harder for retail investors to impact the price, therefore, it will likely not see such impressive gains.
Volatility caused by retail traders has the potential to produce a lasting impact on the markets and in these instances investment strategies focussing on short-term trading may no longer work successfully. Investors should remember that statistically unlikely events, such as the recent short squeeze or the negative oil price seen in April 2020, happen more often than models predict and therefore investors should not rely heavily on these models but have a long-term investment approach.