January brought forth a new set of unanticipated challenges for investors. Fueled by the massive rise of cheap money and free online trading platforms, retail investors seized the opportunity to take from the rich and give to the poor, so to speak. The irony was not lost on market participants that online brokerage firm Robinhood became the poster child for this unprecedented – there’s that word again – volatility in the stock of GameStop, AMC Entertainment, Koss Corp. and others. Interestingly, the earnings for these companies are driven primarily by foot traffic in retail stores (mainly in malls), movie theatre attendance and headphone sales: not exactly three booming business models in the current environment.
But it was precisely because of the secular headwinds in those industries that these were three of the most heavily shorted stocks coming into the year. And that’s where the story got interesting, as an army of traders on the Reddit forum WallStreetBets helped drive a meteoric rise in January:
|Representative||Stock Price as of:||Monthly|
|Companies:||Dec. 31||Jan. 31||Gain|
|GameStop||$ 18.84||$ 325.00||1,625%|
|AMC Entertainment||$ 2.12||$ 13.25||525%|
|KOSS Corp.||$ 3.44||$ 64.00||1,760%|
Source: Yahoo Finance
It got so unbelievably volatile that Robinhood made the decision to halt activity on these and other stocks, alienating their core base. Almost immediately, accusations of collusion and market manipulation ensued, creating unexpected alliances like Representative Alexandria Ocasio-Cortez (D-NY) and Senator Ted Cruz (R-TX). Not much attention was given to the fact that other companies made the same decision: Charles Schwab Corp.’s TD Ameritrade curbed transactions in GameStop and AMC on Wednesday Jan. 27th, while Interactive Brokers Group Inc. and Morgan Stanley’s E*Trade took similar action the following day. Also ignored was that the decision was made to protect the company and their legion of investors given the dangerous volatility in certain names, as stated by Robinhood CEO Vlad Tenev:
“Robinhood is a brokerage firm, we have lots of financial requirements. We have SEC net capital requirements and clearing house deposits. So that’s money that we have to deposit at various clearing houses. Some of these requirements fluctuate quite a bit based on volatility in the market and they can be substantial in the current environment where there’s a lot of volatility and a lot of concentrated activity in these names that have been going viral on social media.”
Source: CNBC, “Robinhood CEO says it limited buying in GameStop to ‘protect the firm and protect our customers,” January 29, 2021.
Nevertheless, almost everyone was furious with Robinhood, as they were seen as “selling out” and putting the interests of certain large, influential hedge funds ahead of retail investors. Many folks then turned their ire to hedge funds, despite the fact that in this case, David beat Goliath. Meanwhile, every hedge fund mentioned during this saga reportedly lost money by shorting these stocks in the face of an epic rally.
Still, with over 8,000 hedge funds the vast majority were largely unaffected by the price action in these individual stocks. And some that were invested were able to quickly rebalance their portfolios without experiencing any real downside volatility. Looking ahead, the dislocation created by certain stocks rising exponentially with others declining significantly – caused in part by the forced selling of liquid longs to cover less liquid shorts by a handful of funds – creates a more attractive opportunity for those managers that weathered the storm well on behalf of their clients.
It’s far too early for any post-mortem, since we don’t know where these stocks will ultimately trade, how retail investors will fare after the eventual return to some form of valuation normalcy, or which hedge funds lost how much money. But we do know that those funds facing the steepest drawdowns had excessive exposure to the factors that always cause elevated downside volatility: concentration risk, leverage risk, and liquidity risk.
Any investment can increase return potential through the use of concentration, leverage, and/or illiquidity, regardless of whether it’s a mutual fund, hedge funds, private capital funds, or company stock. They can also lose money quickly when market conditions shift suddenly. January was yet another case study for risk management during a “black swan” event. As the dust settles, investors should take a careful look at the performance of their hedge fund investments, with a particular focus on diversification and risk management. Those funds that were diversified, with sufficient liquidity and manageable leverage were likely the top-performers last month. They are also ideally positioned to maximize risk-adjusted returns for their clients in the future.
(1) “Alliance” might be strong, as AOC responded to Ted Cruz via Twitter, “I am happy to work with Republicans on this issue where there’s common ground, but you almost had me murdered 3 weeks ago so you can sit this one out.”
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