We are not sure which of last week’s developments is the most peculiar: the term “short squeeze” becoming part of the American lexicon; GameStop shares trading above $300; or a blogging movement, led by a guy in his basement sporting a sweatband and a kitty t-shirt, outmaneuvering institutional investors in a multi-billion dollar trading scheme. The whole thing is weird, but at least the public is taking interest in learning more about markets. We imagine everyone has read or heard multiple perspectives about what has transpired with GameStop, AMC, WallStreetBets, etc., so we will spare our readers a rehash of the situation (if not, you are in a better headspace than the rest of us, and feel free to call us for a quick rundown). Instead, we would like to share some of the lessons we wish the public would take away from this saga but have been all but absent from the ongoing discourse.
Lesson 1: Hedge funds probably are not the enemy unless you are invested in one.
The ubiquitous perception of a fat-cat hedge fund manager that amassed fortunes through market manipulation does not match reality. More likely, the ostentatious lifestyle that the stereotype implies was funded by exorbitant fees accrued from fund investors. A typical hedge fund may charge a 2% management fee plus a 20% share of the fund’s profits, which puts its all-in expenses at least several times higher than the average actively managed mutual fund. For some niche markets, that fee structure may be warranted. But for most, the capacity for outsized returns just isn’t there.
Like any other industry, the hedge fund business has some great operators and many more that do not earn their value. As we’ll discuss in Lesson 2, there is nothing inherently nefarious about how they engage markets. If the public needs a generalized gripe, it should be that hedge funds are too expensive. But we understand that’s a boring narrative that would leave the world in search of a new bogeyman.
Lesson 2: The stock market is not a casino except to those who treat it as one.
Those who jumped on the GameStop bandwagon seemed to believe they were joining a carnival game that was suddenly rigged in their favor. They perceived markets as a zero-sum game in which professional investors exploit an ill-gotten edge to extract money from the public, and the GameStop saga was an opportunity to become the “house” for once. So when the brokers like Robinhood shut down trading at the moment the tables finally turned against pros, they all but validated that Wall Street was conspiring to keep retail investors out of the game. The problem with this cynical perspective is that it imputes far more capability on the industry than deserved.
Institutional investors who shorted GameStop believed that the company’s market value was too high relative to its financial prospects. Perhaps trading on that view was callously opportunistic, but their odds of realizing a profit are no better than for anyone else who shorts the stock. Outside of deliberate market manipulation, which is illegal and is catnip for regulators, how could they “stack the deck” in their favor? Institutional investors do not operate within a structure resembling a roulette wheel with a well-defined probability distribution, and they cannot predict the future. That covers any basis of an unfair advantage.
If anything supports the perception of a “rigged” market, it is seeing GameStop’s market value begin January at $1.5 billion and end the month at $21 billion without a proportional catalyst. The primary WallStreetBets trader behind GameStop’s ascent did his homework on the company’s fundamentals and believed the stock was excessively shorted. The Reddit group paired that kernel of fundamental analysis with the “Wall Street is evil” narrative and recruited an army of traders to join its cause. A cause that wasn’t to see GameStop’s share price reflect the company’s intrinsic value but was instead to maximize gains, whatever the source.
What we’ve seen over the past couple of weeks is the closest thing to a casino that financial markets can deliver. People who bought into the frenzy engaged in a zero-sum game based purely on speculation and against odds that were indubitably stacked against them. Ironically, that group was on the same side of the table as the hedge funds many demonized. “The house” was the early cadre of WallStreetBets traders who orchestrated the short squeeze. They extracted value from the hedge funds on the way up, then from the late adopters who will ride the stock back down.
Over the long-run, markets reward (or punish) investors by how well they allocate capital toward financially productive ends. Those who invest judiciously will reap rewards that markets can realistically deliver. A lucky few will bear massive risk and experience the sort of overnight windfall that market skeptics believe is commonplace on Wall Street. And the skeptics will continue losing out as they chase their own windfall opportunities which never materialize.
Lesson 3: Trade commissions were never the problem and never really left.
If investors knew the life of a commission-free trade, they might wish for a return to how things were. In lieu of what was a commission charged directly to customers, brokers now receive what’s called “payment for order flow”. Payment for order flow is the kickback that a market specialist, like high-frequency trading firms, pay brokers for the privilege of executing their orders. Why would a specialist pay to execute someone else’s orders? The specialist shaves fractions of a cent off every share of every order they execute - buying or selling.
This payment for order flow arrangement yields billions in revenue for brokerage firms who can now claim clients are receiving a free trade. So rather than feeling the sting of a commission, investors now receive slightly worse trade execution that costs them some unknown amount.
To someone serious about investing this hidden cost might be troubling, but it should not change their trading behavior. If a nominal commission is the difference between placing an order and not, the trade was not likely worthwhile in any case. Unfortunately, our newest crop of investors operates as though a commission was the barrier between them and smart investment decisions. Hopefully, this rash of speculation will bring those investors to reconsider their approach.
Lesson 4: There is nothing to fear but the fear of missing out.
All the lessons above are moot if it were not for the fear of missing out. FOMO is the root of whatever animus people harbor for hedge fund managers. FOMO is what drove hoards of individuals to pay five times revenue to own shares of a struggling videogame retailer. FOMO is the motivation for millennials to use what savings they have to day trade options on a “commission-free” platform. And FOMO is driving the speculative frenzy for the latest easy-money invention: special-purpose acquisition companies (SPACs).
A SPAC, also known as a “blank-check company”, is a shell entity created for the purpose of buying an unspecified company at an unspecified date within the next two years. In other words, its purpose is TBD. The functional purpose of a SPAC is to take a burgeoning company public without the headaches of an IPO. However, the cost of circumventing the IPO process is that SPAC investors don’t know what company they are buying until the SPAC’s management team finds one.
If this sounds like a reckless idea, you better believe a flood of capital is flowing in its direction. Case in point: the February 2nd SPAC-of-the-day raised $900 million and “expects to focus on leading companies across a variety of industries with attractive growth-oriented characteristics and strong underlying demand drivers and with all or a substantial portion of activities in North America and/or Europe.” Evidently, one does not even need to pretend to have a compelling story to raise nearly a billion dollars.
Like nearly any vehicle of its kind, SPACs were created by institutional investors for a particular use case. The idea worked well for those investors and now it has exploded in popularity, particularly among those who don’t want to be left out of the next movement. Whether it is SPACs, shorting volatility, cryptocurrency, auction-rate securities, Reddit subgroup targets, dot.com companies, or tulips, investment crazes, even those founded on compelling themes, see a surge of euphoria before incinerating mountains of wealth. So if the feeling arises that a highly profitable and urgent opportunity is slipping through your fingers, try taking a step back to remember that investments usually become exciting only after they deliver the windfall and the upside is likely scant if the herd is already moving in the same direction.
For us, public enthusiasm for investments is generally cause for concern about prevailing perceptions. Whenever equity markets become too dull to satiate investors’ risk appetites, valuations across all asset classes tend to be dislocated from fundamentals. The current environment does not appear to be an exception. Therefore, we believe it is prudent to downshift within portfolios that have been above their strategic growth allocation targets and allow for valuations to recalibrate and reflect a healthier appreciation for the risks to this recovery. As always, we are grateful for the responsibility to oversee portfolios through periods of mania, despair, and everything between.