Markets were stunned at the end of January when a collection of individual investors, using low-cost trading platforms like Robinhood, started to buy up shares in US video games retailer, GameStop, in a bid to cause a so-called ‘short squeeze’.
Some hedge funds, who were the targets of the squeeze, had been short-selling GameStop stock, borrowing shares of the stock to sell on the open market with the intention of buying them back at cheaper prices in anticipation that share prices would fall.
Buying a share limits the potential loss to the initial investment, however shorting a share can theoretically increase the losses beyond that as the price of an asset can climb indefinitely.
As such, investors bidding up the price of GameStop saw hedge funds suffer spiralling losses, and in a controversial move, trading platform Robinhood restricted access to the stock of the company. The move drew criticism from all corners, suggesting it was done to protect the interests of hedge funds, which make up a large proportion of Robinhood investors.
Performance of GameStop over 1yr
Source: Google Finance
“There has been a growing feeling of distaste that the very top of society – those who run huge hedge funds for example – have not only not been hurt by the recent coronavirus-related upset to economies, but have outright benefitted from it,” said Ben Conway, head of fund management at Hawksmoor Investment Management.
“This was far more than a bunch of insomniac bored gamers stuck at home punting stocks,” said Conway. “This was a co-ordinated attack by people who know how options work. They know that when they buy call options, the investment banks selling them these creations have to buy the underlying stock to hedge themselves.
“They know that when they buy a call option, they can lose everything, but they can also put up very little capital for a huge amount of upside.”
Therefore, if enough people do this, the short sellers will also have to buy the stock to stop the losses becoming too great for the firm to bear, which is exactly what happened to Melvin Capital Management.
“Melvin now has its place in history as the fund that lost 50 per cent of its value by betting on a fall in the stock price of a floundering US video games retailer, GameStop,” said Jim Wood-Smith, chief investment officer of private clients and head of research at Hawksmoor Investment Management.
“Melvin has had its 15 minutes of infamy,” he added. “This time next week it will have been forgotten.”
Indeed, it has, but in the midst of this event, short-selling has come under scrutiny, but is it perhaps unfair? Trustnet examined the role of short-selling and its role in markets more keenly.
Wood-Smith said short-selling has many tangents, although conceded it comes with an awful reputation.
“So-called short sellers are generally portrayed as having horns and tails and carrying pointy tridents,” he said. “They are the heartless, cold, cruel capitalists who drive good companies out of business and loyal workers into homelessness and poverty.
“To borrow the description once made of Tiny Rowland, they are portrayed as the ‘unacceptable face of capitalism’.”
This, he explained is a tad harsh and ignores the legitimate role shorting plays in the market.
“A fund manager may look not only to those shares that they believe are going to rise, but also to those that may fall,” he said. “But one may also have a view on how one share may perform relative to another, regardless of whether they are rising or falling.”
Wood-Smith used the example of oil giant BP, which if it was deemed to be a better bet than ExxonMobil, an investor would buy BP and short (sell) Exxon. The return would be the difference in the two share prices.
“As a matter of principle, we do not have an issue with shorting,” he said. “When executed properly and when done for the right reasons, it is entirely compatible with sustainable investment.
“It is just as logical for a fund manager to short an oil company – on the basis that its business will eventually disappear – as it is to own manufacturers and owners of wind farms,” said Wood-Smith.
However, the narrative that the ‘short squeeze’ was a “peasants’ revolt” against “masters of the universe” hedge funds was “deeply-flawed”, according to Barry Norris, chief executive and fund manager at Argonaut Capital.
Norris warned of the dangers of short-term share price manipulation and the dangers of investing based on price momentum.
“When inevitably these dry up,” he added. “With no commensurate improvement in the company’s trading prospects – then the stock will eventually collapse.
“Many hedge fund managers – those who offset long positions by selling stock they do not own in the belief it is overvalued – are in fact industry outsiders,” said Norris. “Indeed, short-selling in a bull market is not an easy living.
“Although widely seen as malicious, in fact it only succeeds if an unpalatable truth is discovered.”
He highlighted German payments company Wirecard as an example of the kind of companies that short sellers can unmask.
“With the rest of the investment industry motivated solely by higher prices, without short sellers, these crimes may have never come to light,” he said. “If there are no short sellers to play the role of market vigilante, we would inevitably have a more dishonest stock market.”
Norris also noted that liquidity is crucial for companies and a higher share price can make it easier for companies to raise funds.
“However, the stock market should make capital raising easier for companies with better growth prospects and more difficult for the rest,” he said.
After reaching a high of $348 a share on 27 January, as of 9 February, GameStop is trading at $47 a share.