‘Game over’ for hedge fund

As Reddit community forces it to get a $2.75bn (R41.5bn) bailout.
Image: Shutterstock

Oh, how the mighty have lost fortunes.

Several hedge funds like Melvin Capital and Citron Research thought they were onto something when they started to ‘short’ shares in GameStop, a brick and mortar gaming store that supposedly had an obsolete business model.

The thinking was that they could make money from the expected slide.

But they made a big miscalculation. Instead of seeing the value of GameStop shares fall, over the past few months the share price rose and in the past few weeks it skyrocketed.

GameStop, which was trading at $4.21 a year ago, had risen to $18.81 by the end of 2020 and shot up to $472 on Thursday.

So how did the likes of Melvin Capital, which had to be bailed out to the tune of $2.75 billion (R41.5 billion), and Citron Research get it so wrong?

On the surface, they had a solid investment thesis …

A business that sold games through stores (think Musica) would soon be upended by digital distribution rivals.

They reasoned that by ‘borrowing’ shares and then selling them at the current price, they would make money by later buying shares at a cheaper price than they had been priced at when they initially sold them. These shares would then be returned to whoever they borrowed them from.

In effect, the short seller sold something it did not own and planned to make money by buying shares at a lower price than they had sold them for in the future.

But two things happened that they didn’t count on.

The one is that GameStop got a new shareholder in Ryan Cohen, a man who made his money founding and running an online pet food and related products group called Chewy.

Cohen ended up taking a 13% holding in GameStop, and engineered some former Chewy executives onto its board on January 11.

Now things are different at GameStop. Its prospects have changed for the better as it is now effectively being run by people who have the skill set to help it adapt to a digital distribution sales model.

GameStop also got a lift from the launch of the PlayStation 5 and new Xbox gaming consoles, which are expected to boost sales.

The other thing they didn’t expect was a ‘short squeeze’ sparked by the two million members of the Reddit community WallStreetBets.

WallStreetBets members knew the hedge funds had tried to short GameStop, which meant they would at some stage have to return the shares they had ‘borrowed’.

The WallStreetBets members also knew that the funds would pay anything to cover their position when it became clear that GameStop’s prospects had changed for the better.

So they bought up as many shares as possible and waited for the hedge funds to start panic buying.

This resulted in a spike in the share price as the hedge funds would basically pay any price to get hold of shares to ‘return’ to their owners.

The resulting kerfuffle has not only lost and created fortunes, it has also drawn scrutiny from some powerful people.

US senator Elizabeth Warren has called for regulators to take a look at the behaviour of the hedge funds.

Treating the market ‘like their own personal casino’

“For years, the same hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades have treated the stock market like their own personal casino while everyone else pays the price,” Warren said in a statement.

This is not just sabre-rattling as Warren is a leading member of the Democratic Party, which now has control of both legislative houses and the presidency. The Democrats also tend to take a more jaundiced view of Wall Street than their Republican counterparts.

Some on Wall Street also want the regulators to take a closer look – but for different reasons. They want an investigation into price collusion between the smaller-time investors for pushing up the price.

One way of viewing what has happened at GameStop is that this was a once-off, and that the fancy hedge funds have learned their lesson after being given a walloping by 20- to 30-year olds sharing stock market memes on an internet forum.

Another is that this is just a bit of creative destruction on the part of the market.

Something quick and nimble gobbled up something slow and fat.

I don’t think it is a once-off.

I think there has been a profound shift. The mob strength of retail investors proved they were more than a match for the balance sheets of some of Wall Street’s largest heavy hitters.



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Maybe some reform is required to prevent the hedge funds from thinking they own the stock markets or sovereigns.

Oh, let’s be pragmatic now, leave them be. I have never made such a neat bundle in a blink of an eye, thanks to WSB and their ‘weaponized autism’ as they call it.
Let’s play by the same rule, only let the small investors find them and what they are up to gambling on the livelihoods of small investors. Don’t change the rules now when the ‘little’ or ‘unsophisticated’ guy has found a way of winning! What’s this with manipulating the internet and calling the SEC and others to ‘investigate’ when all people (we) are doing is trying to invest and make a tidy sum. They say the stock is going down is okay, but if we say the stock is going up, we are stopped!! C’mon now. They can place a bet, and win; but when we call the bluff they can call the coppa’ and hijack the system? This is is what is rigged –

Getting some of their own medicine . Why bail out ? Nobody bails out a small private investor. Rather bail in for all that invested in this hedge fund.

Exactly, either bail out everybody or nobody.

It should be the same in the job market.

There is more to this than meets the eye. The new American Treasury secretary, Janet Yellen, is implicated in this mess.

She received around $810,000 in speaking fees from Citadel, the hedge fund that bailed out one of the primary losers in this debacle. The Xiden regime is completely beholden to Wall Street, that much is clear.

The “too big to fail” companies always get a bailout. That’s how the rigged system works. Big money and politics operate on a quid pro quo system, and the taxpayer foots the bill.

Yes yes. Well done, this is what I consider good mob speculative investing. Its a huge reversal of the norm.

How can we have such financial action here on Moneyweb? Who wants to be the Field Marshall of an army of legal corporate raiders?

We already have Field Marshall Nakamoto who has given us all the weapons we need…

But just who are engaging in hedge funds? Any given asset management firm may manage a combination of externally-defined hedge fund and non-hedge fund assets. Pension schemes and other big institutional investors usually have a discrete asset allocation bucket for hedge funds.
There is no evidence to support the notion that that the Reddit posters are little fish taking on the establishment, just as there is no evidence that these supposedly much-adored posters are not on the payroll of some big institutional investor, for the purpose of directing the little fish into a waiting net.

I’m thinking that you haven’t spent much time engaging with these communities. The little fish clearly have nothing to do with corporate money.

Tell it to the commandeered media.

“They reasoned that by ‘borrowing’ shares …”

Why is borrowing in inverted commas?

Per https://www.macmillandictionaryblog.com/the-emphatic-use-of-quotation-marks “Quotation marks … are normally used for quotation … or to enclose a foreign, technical, or otherwise potentially unfamiliar word. … Quotation marks can also highlight that a word is being used somehow peculiarly – a writer may wish to indicate irony, inaccuracy, or scepticism, for example; used this way, they’re called scare quotes.”

Because they aren’t really borrowing anything. They’re selling something which they don’t own.

Not sure Uncle. The selling is real, the borrowing is real … both are underpinned by enforceable contracts. The delivery of the scrip to settle the transaction is real, until it’s not and there is a failed trade.

In my books when you sell something you do not own it is called fraud. Yet short selling in common place. So Fraud is accepted practise.

Alright, who has been shorting shares on the JSE the last 3 years?

These traders will do anything for commission.

“On the surface, they had a sold investment thesis …”, did someone proof read this or did they spell check it?

Perhaps ‘sold investment thesis’ is not a typo but instead a fancy term for shorting 🙂

Fundamental or value investing is dead.

You don’t know what is priced in or not.

Tesla , case and point.

Trading is gambling on the views of the majority .

Interesting times

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” – Warren Buffet

I disagree with you on value investing. I believe it is not dead. Tesla was a good buy based on Elons past history with creating companies. If you understood what potential a company can have, and have the gut to weather the emotional tides, long term investing is definitely not dead.

There are more emotional investors today than there were back then, and the understanding what the difference is between investing and scalping trades are two different things.

If The Hedge fund companies used their exact model which they used on Gamestop, on another company such as BLOCKBUSTERS, they would be VERY wealthy right now.

Value investing cannot die, it only hibernates for a decade or so. The price always reflects the value at some stage, but not at every stage. Momentum investing rules during those periods when the perceptions about value have to catch up with the realities of value. Currency devaluations and credit expansion drive momentum investing and always catches the value investors off-balance because they calculate the value in terms of a stable unit of account. The unit of account is rarely stable though. It is like putting diesel in a petrol engine.

Value investing rules when the inflation-adjusted yield on the risk-free rate in the USA is positive, and momentum investing rules when the real yield on the risk-free rate is negative. You should know when to chase value and when to chase momentum. For some, it is like the choice between a girlfriend and a wife. You have the best of both worlds when your girlfriend is your wife.

Have you not seen the low cap crypto markets?

The investor who owns the shares earns interest by lending the script to the hedge fund who sells it to buy it back later at a profit. The hedge fund cannot manipulate the price downwards without the help of the investor. The investor owns the shares because he believes in the bullish case. The hedge fund sells it short because they believe in the bearish case. The future will tell who is right and who is wrong, who profits and who loses. This is the market. There must be a seller for every buyer otherwise there won’t be a transaction. Hedge funds, speculators and short-sellers provide liquidity for investors to buy and sell when they want to.

Speculators and short-sellers lubricate the cogs of the system so to speak. This example proves that short-sellers cannot manipulate the price lower than where the fundamentals allow it to be. If the short-seller is wrong in his assumptions, he will have to cover his position by turning into a buyer to push the price upwards to where it should have been in the first place.

The current price is merely the condensed summary of the perceptions about value from buyer and sellers after they have studied all the available information.

Interesting but where did the hedge fund find the owners of 130% of the issued shares?

The open interest on derivates instruments can be, and usually are, many multiples of the issued shares or physical commodity. At the date of the closeout of the futures contract or the expiry of the options contract, the open interests are zero again as longs and shorts close their positions. The derivatives market does not use script lending, it uses the margining system to ensure performance. It offers a more sophisticated, less cumbersome and cheaper mechanism to get positive or negative exposure.

I’m sort of answering your answer to my question (which comes from the CNBC interview) and not quite as per your earlier statement “investor who owns the shares earns interest by lending the script to the hedge fund”. Obviously this hedge fund was running a smoke and mirrors betting game unrelated to actually borrowing any scrip, but underpinned by the knowledge that they would be bailed out.

Agreed. Though there may well have been derivative trades contributing to pricing of the underlying share, the fact (?) that the shorts exceeded the shares in issue is symptomatic of naked shorts (shorts without the shorter having borrowed the scrip or secured a commitment to borrow the scrip from the registered owner of the scrip) rather than derivative trades.

There is a great business case for spotting an overvalued stock and shorting it but only if you are doing it LOOOOONG before we get to situation like this (80% short interest). By then everybody and his dog is “clever” which is not possible in the real world.

Gotta love the guys involved in this bloodbath: YOLOS
You Only Live Once (expressing the view that one should make the most of the present moment without worrying about the future, and often used as a rationale for impulsive or reckless behaviour)

And like the famous economist John Maynard Keynes said, “the markets can remain irrational longer than you can remain solvent.”

I loved the paraphrased quote some degen made, “I can stay retarded longer than they can remain solvent”

Why do they call shorting a specific stock a hedge activity? It is nothing of the sort. It is a pure punt.

A hedge in regard a single share would be if I owned say Apple, it has run a lot, I don’t want to sell (can be many reasons) I buy put options to hedge against a correction.

It is pathetic that they now want to stop crowd cooperation to squeeze shorts!

If regulator wants to change things – introduce a minimum holding period of any position of 100 days. That is investing. Taking any position with an outlook shorter than 100 days is speculation (or insider trading more often than not) That will also take out the high speed arbitrage trading where a bot buys and sells in seconds.

Well stated Johan.

The entire principle of publicly traded stocks have been perverted. It has migrated from the ability to access capital for GROWTH in return for a risk related reward for the investor to a purely speculative orgy of greedy gambling. Totally agree with your point of a minimum holding period whether it is 30 or 100 days. This will fundamentally change the behavior of the “markets”. It will also return to the level of activism of the shareholders in the executive management of the listed companies. Boards are less accountable now since the shareholders are either only interested in the share price increase, or shorts actively want the business to fail.

Very interesting Gamma squeeze!

This is very healthy for the markets…

See blog post for more detail: Credit where credit’s due: the $GME short squeeze was brilliant! https://nosible.com/credit-where-credits-due-the-gme-short-squeeze-was-brilliant/

Which is why Wall Street shut them down. All profits are supposed to go to insiders, or didn’t you know? Wall Street hates outsider trading when it makes money.

It is always those “low risk” trades that bankrupts a hedge fund. Ask the Nobel Prize Laureates at Longterm Capital Management who almost took down the entire financial system with their ultra low-risk bets on the Russian government bonds in 1998.

The belief that house prices never decline and that “bricks and mortar” is a sure bet, led to the popularity of CDOs that caused the biggest financial crisis in history in 2008.

Many savers are risk-averse and they avoid the risks on the stock exchange to buy into a “sure thing” and promises of risk-free profits by investing in a Ponzi-scheme.

It is almost like people who buy the high-yielding “risk-free” government bonds of a nation like our’s, that is on the brink of a sovereign default.

Not the first hedge fund ‘managers’ to demonstrate their risk management skills…

Whether it’s a mob of retail investors or a couple of big funds with the opposite view, it makes no difference : if you don’t watch your shorts they end up round your ankles.

For a long position the potential loss is capped as the share price can only go to zero. For a short position, potential losses are uncapped, so things can get messy.
To go against the grain and specialize in identifying shorts requires a lot of skill, patience, and luck. I take my hat off to people who do this for a living. The abundance of cheap money has probably made this job a lot harder.

Shorting lubricates. Naked shorting should be made illegal and acted upon.

Agreed. But I thought naked shorting (which I understand to be shorting before having borrowed or entered into a commitment to borrow scrip from a registered owner) was already illegal? Maybe the enforcement of the regulation is weak or hamstrung.

The bigger story here is how the QE programme by the Fed for more than 10 years now has lead to speculative bubbles peddled by Wall Street. Now add the stimulus cheques for anyone who has a pulse,you get a feeding frenzy for a few good companies and helluva a lot of bad ones.

I love it. As a member of WSB, we will continue this, wait till you see what happens next:D. If 2020 was the year of revelations, this year will be the year of REFORM.

Interesting that overall (entire S&P) short position is so low (under 2%) given record bill run since March 2009.

End of comments.



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