When the music stops

February 2021

You may have read or heard something about Game Stop, and hedge funds, and Reddit. You could be forgiven for thinking that this is nothing to do with you, and it’s all too esoteric, but there are lessons to be learned.

Before I get into the issues, I will try and explain what’s going on. Please stay with me, because this is important, but if you don’t want the detail, you can skip down a bit, where I summarise the lessons.

GameStop is a US-based retail chain, selling video games from physical shops. Given that the high street is dying, not helped by the covid pandemic, the business is loss-making, and its shares had gone down to about $20 at the end of December 2020. However, by the last week in January, the price had gone up to nearly $350. How? Why?

Enter hedge funds, and short-selling.

As well as simply holding shares to benefit from the long-term growth and the ongoing dividends, hedge funds seek to benefit when shares go down in value as well. They do this by a process called short-selling (or simply ‘shorting’).

Let’s create a theoretical example, a company called OneShare, which has been going through hard times, and the share price has gradually gone down to £20. A hedge fund manager thinks that there is more bad news to come, and that the price will go down further, he thinks to £15. He doesn’t own the shares (because he thinks they’re a bad investment) so he borrows some shares – let’s say 1,000 shares – from an index fund manager or a broker, and immediately sells them for the £20 they are worth today. He needs to pay the person that lent him the stock a small amount of money for the privilege, but let’s not make this any more complicated than it needs to be and assume he now has £20,000 in the bank – £20 times 1,000 shares equals £20,000.

So far, so understandable.

If everything goes as he thinks it will, the shares go down to £15, he buys back 1,000 shares which are now only costing him £15,000, and hands them back to the stock lender (less the aforementioned small fee).

He has made a profit of £5,000 (less a little bit in fees) even though the share price has fallen.

That’s what had happened with GameStop. Hedge fund managers had decided that the share price had lower to go and had shorted the shares.

Perfectly legal, happens every day of the week.

But now it gets interesting. A group of amateur investors, inspired by posts on social media and especially Reddit, decided to start buying shares in GameStop. Now, if one or two, or even one or two hundred people buy shares in a company, it makes a small difference, if any at all, but if all of a sudden thousands of people start buying, and starting doing so in large volumes, the price of the stock will go up. And go up it did, at one point to nearly $350.

That’s a problem for the hedge fund managers. Let’s go back to our OneShare example. If the share price, instead of going down to £15, goes up to £50, the fund manager still has to buy the shares (he sold them for £20, remember) to give back to the stock lender and he has to fork out £50,000 for the 1,000 shares that cost him £20,000. It doesn’t take a mathematical genius to realise that, instead of the profit of £20,000 he was expecting, he has a cash loss of £30,000.

The hedge funds will definitely be the losers here, not the stock lenders. The hedge fund has to put up collateral – security, if you will – in the form of very safe instruments, like cash or bonds. Not just to the value of the loaned shares, but to cover a safety margin. When it looks like the value of the loaned shares is becoming more than the collateral, the lender will ask for more collateral or their shares back. Either way, it’s going to cost the hedge fund money – lots of it.

These guys don’t deal in amounts of a few hundred shares – they deal in thousands and thousands of them. In the GameStop example, if the shares were borrowed and sold at the December price of $20, and the lender called in the loan at $300 (or more) that’s a loss of $280 per share!

Do the arithmetic – every thousand shares is $280,000; every million shares is $280,000,000. One estimate sets the hedge fund managers losses at $13 billion (that 13 with nine zeroes).

(If you skipped the technical explanation, you can rejoin here.)

What are the lessons here? Surely nobody cares if hedge fund managers lose money?

It’s not their money

Hedge fund managers play with other people’s money. To be absolutely fair, many, maybe even most hedge fund managers have ‘skin in the game’, but most of what they are investing (or speculating, as I see it) is other people’s money that has been entrusted to them. That being the case, it’s not the hedge fund managers who are the big losers here, it’s those that have invested in the funds.

It’s against the law

Banding together with a view to drive prices up (or down, for that matter) is called ‘market manipulation’ and is illegal in most developed countries. It is in the UK, and most certainly in the US where GameStop is listed.

In fact, a group of fund managers have made representations to the Securities & Exchange Commission (SEC) to the effect that if they had agreed to work together to drive prices up in this manner, they would (rightly) have been hauled over the coals.

People have gone to jail for market manipulation. You may remember the Martin Scorsese film, The Wolf of Wall Street, inspired by the true story of Jordan Belfort, a stockbroker who was jailed for defrauding investors of $200 million in this manner, and in fact is still repaying them.

It’s incredibly dangerous

There was a reason GameStop’s shares were only worth $20 in December: the combined opinion of all the buyers and sellers using all the information available arrived that figure. There is just no way that a company that was worth $20 a share in December was worth more than 15 times that less than a month later.

In an outbreak of irony, Jordan Belfort himself, the real ‘Wolf of Wall Street’ has warned that the amateur investors getting caught up in the excitement of the moment could lose everything.

He is in the process of being proved right – the shares have come all the way back down and are trading around $50 per share. Anybody that bought shares in the frenzy stands to lose most of what they invested.

There are no winners

Well, that’s not quite true – there will have been some people who had been holding shares valued at $20 and were able to sell at $300 or more that can’t believe their luck!

But in the broad scheme of things, it’s true.

The hedge fund managers who tried to guess where the market was going and bet their money (and other people’s) on it have lost out – big time.

And the amateur investors who got caught up in the excitement of the moment and bought shares look like they are going to lose out – many already have.

Please don’t try to beat the market. Very rarely does it end well.

As ever, we would be glad of your feedback and questions on this or any other financial planning topic. If you need help about a specific matter, please get in touch – I or one of the financial planning team will be glad to help.

Important note: past performance may not be a reliable guide to the future; the value of investments can fall as well as rise, and you may not get back everything you invest

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