If you’ve been paying even slight attention to the news this past week, you’ve probably heard about the historic price movements in GameStop (GME) stock, the Reddit / Main Street vs Wall Street hedge fund narrative, and multiple interpretations of what it all might mean. I’m not going to try and interpret the larger ideological significance of these events. What I will attempt to do is alleviate some confusion about how the securities markets work and how that informs the context of the story.
But before I get to that, a disclaimer: This article is provided solely for informational purposes and should not be construed as personalized investment, trading, or financial advice. I make no representations or warranties of any kind as to any of its content or the accuracy thereof. All investments carry risk, and you should consult with your financial advisor, accountant, and/or attorney prior to making any investment or trading decisions.
What is a Hedge Fund, Anyway?
The term ‘hedge fund’ has become synonymous with Wall Street greed, but is that an accurate, blanket characterization? A hedge fund can roughly be defined as an investment vehicle for accredited/sophisticated investors (who meet certain standards of income or net worth) or large institutional investors which, due to the restricted nature of who is allowed to invest in the fund, is subject to less regulatory requirements than other types of funds open to the general public (like a mutual fund). In other words, hedge fund managers typically have a lot more discretion than mutual fund managers, but you can think of a hedge fund as being kind of like a mutual fund for wealthier investors. Beyond that, hedge funds vary widely. While most people think of Wall Street elites trading billions of dollars in capital, there is actually no set minimum for the size of a hedge fund, and there are even very small hedge funds which may only manage about $5–10 million in capital.
Who Runs Hedge Funds and How Do They Make Money?
A hedge fund is typically structured as a Limited Partnership. This is a legal structure in which there are General Partners (GPs) and Limited Partners (LPs). The LPs provide most (sometimes all) of the capital, while the GPs actually manage the fund. LPs may consist of high net worth individuals, but most of the time are institutional investors like pension funds, banks, credit unions, insurance companies, state-owned enterprises, or endowed charities.
GPs are paid an annual management fee based on the total assets of the fund (historically about 2%) to cover their operating costs. The big gains for GPs come from carried interest, which is a percentage of the fund’s gains beyond a certain minimum hurdle rate. For example, the hurdle rate might be 10% annualized, and so for any gains the fund makes beyond 10% during the year, the GPs may receive 20% of those gains as carry. Most of the profits and losses are passed on to the LPs. If the GP fails to meet the hurdle rate, they earn no carry. Some funds also use a high-watermark system where the GP only earns carry if the fund exceeds its historical peak.
With some quick math, it’s easy to see that managing a smaller hedge fund isn’t as lucrative as many think. Even managing $50 million, the annual management fee would likely be no more than $1 million (maybe less), and out of that the GP has to cover all its expenses and overhead, including staff, trading costs, technology and infrastructure, research, fundraising for more LPs, etc., which may only leave the fund manager with a salary comparable to a doctor or attorney. And if the fund doesn’t beat the hurdle rate and/or watermark, there’s no additional compensation. It’s still a high-paying job, but not necessarily the aristocratic luxury that many people think, especially considering the long hours worked and tremendous pressure to perform in an increasingly-volatile market.
Of course, there are also mega hedge funds which manage multiple billions of dollars and where the managers are incredibly wealthy, but most funds are smaller than that. Also, the industry has been suffering for years due to poor performance compared to other asset classes, included the general market (e.g., S&P 500), which has lead to fee compression, missed performance targets, and LPs abandoning ship. Overall, it’s not a great time to be a hedge fund manager outside of the biggest and most successful firms, so the assumption that ‘hedge funds’ in general are all the cash cows of Wall Street billionaires is simply incorrect.
However, it is true that very large hedge funds are often deeply-integrated into the securities markets. The advent of high-frequency trading, payment for order flow (which is now mainstream due to the rise of commission-free trading), and other like developments have created a situation where top hedge funds are essentially required for the market to operate in its current form. This is not to say that it should be this way, but rather, this is how it currently is.
What’s the Deal with Short Selling?
Shorting is another part of Wall Street that is often the subject of criticism, but in and of itself it’s rather innocuous. In contrast to a long position (owning a security believing its value will appreciate), a short is simply where the trader borrows a security and sells it, expecting the price to go down. If it does, the trader can buy it back at the lower price, repay the lender, and pocket the difference as profit. This is a strategy accessible to everyday retail traders as well as as institutional traders, though by law shorting has certain capital requirements because it essentially creates a credit position. Shorting can only take place in a margin account, and regulations require certain minimums of capital to be maintained relative to the amount of credit/margin the trader is using. In other words, traders have to maintain a certain degree of liquidity to help make sure they can pay their debts if the short trade goes against them, typically in the form of cash or long securities (which can be liquidated for cash). If they can’t pay their debt, their broker is liable to cover for them.
What is a Short Squeeze?
Shorting is also an incredibly risky strategy because it has potentially unlimited downside. The maximum profit from a short trade is a the difference between the price at the time of the short and the price at which the trader closes the position. If a trader shorts a stock trading at $50, the lowest the stock can go is $0, so the trader can never make more than $50/share on the trade. However, the maximum possible price of a stock is theoretically unlimited, meaning the loss potential is also unlimited if the trader is unable to close their short position.
A short squeeze happens when the trade goes against short-sellers and the security starts to quickly rise in price. The short trader then buys back the security at a higher price and takes a loss to close their short by repaying the initial lender. They may do this to prevent further losses in case the price trend keeps rising, or they may receive a margin call where they no longer have the minimum capital relative to what they owe and are forced by their broker to liquidate. As more and more short traders rush to close their short positions, the increasing demanding for the stock creates a spiral that pushes the price even higher.
Is Shorting Bad for the Markets?
Shorting can be used for bad purposes, but the practice itself isn’t bad, and in some cases it adds a lot of value to markets. Some people don’t like shorting because they don’t want to bet against a company. However, stocks trading on the exchanges are in the secondary market, meaning the transaction is between one trader and another. The only time the company gets money from a stock sale is in the primary market, which most retail traders will never see.
But if a company’s stock price goes down, doesn’t that hurt the company? It depends. In and of itself, stock price has no effect at all on the operations of the company. But if the company owns a significant portion of its own stock, a decline in price will reduce the value of those assets. It also means if they need to issue stock in the future to fundraise, or as part of a compensation package, they may have to issue more shares than they would have wanted. But there are trade-offs even to these things. For example, the company may want to hold more of its stock to retain greater control, or employees may want to be paid in cash rather than stock grants because it’s more stable. Some people seem to think that stocks should only go up all the time, but this is not practical. The market depends on both buying and selling actions to function, and without prices moving both up and down relative to other things that traders value (i.e., cash), there wouldn’t be a market at all.
Second, and perhaps most importantly, short-sellers help to prevent bubbles by detecting failing companies (and in some cases, even help to deter securities fraud, specifically pump & dump scams). Because they are looking for problems with companies, short-sellers often see things that long traders may not. Short-selling then provides negative pressure on the price of securities which otherwise may have a tendency to get inflated due to corporate PR campaigns or the unrealistic claims of executives, or even the outright lies of pump & dump scam operators. Some of the loudest voices for banning short-selling come from the ranks of executives who have a substantial portion of their personal net worth in their own company’s stock. By betting against companies with questionable fundamentals, short sellers serve as a reality check on the markets and help stop prices from inflating to absurd highs.
So What Happened with GameStop?
GameStop was one of the most-shorted stocks on the market, and a significant portion of those shorts were held by large hedge funds. Certain traders, such as Michael Burry, believed that there was a legitimate business case for GameStop stock to appreciate, such as the roll-out of the Playstation 5 in which some models still accepted disks, which could arguably lead to several years of stable revenue in GameStop’s future. In late January 2021, the price of the stock was rapidly bid up due to widespread demand based on what seems to be social media activity primarily coming from Reddit, causing a short squeeze and forcing the hedge funds (and anyone else who happened to be holding a short position in GameStop at the time) to either close their positions or potentially face unbounded losses. While small-time retail traders definitely played a key role, based on the sudden, historic price movements it seems likely that there also may have been very large traders at work bidding up the price simultaneously to capitalize on the trend. What resulted was GameStop stock reaching a historic price, seemingly completely unaligned from the fundamental strength of the business.
Many retail traders who participated were likely following the trend and just trying to make some money, while others claimed on social media to be motivated by ideological reasons. Ironically, those who got involved due to anti-Wall Street, anti-billionaire sentiment may have just helped to transfer substantial wealth from one group of ultra-high net worth hedge fund investors to a different group of ultra-high net worth traders and investors. And as for the losses taken by the hedge funds, remember that typically most losses are absorbed by the LPs, not the GPs (who actually run the fund). While the GPs will almost certainly take a loss in carry, and maybe some of their own capital, and potentially even in their professional reputation, most of the financial loss will likely be passed on the LPs, which may include pension funds, insurance companies, credit unions, and charities which service some of the very same people who set their sights against the hedge funds. In addition, there are already other effects happening in different parts of the market due to shock waves from this event. Again, this is not to say this is good or bad; it’s simply to point out the facts of how these things work. The scope of ramifications from this event, especially if something like it happens again, is yet to be seen.
Are Market Operators Allowed to Halt Trading on a Stock?
Many inexperienced trades were shocked when trading was halted on GameStop, thinking it must be unprecedented. In reality, trading halts take place all the time. It often happens if the regulators or market operators believe that market manipulation is occurring. Sometimes it will happen around the time of major news events, or if there is very unusual price action in a security. Exchanges and brokerages are under certain regulatory obligations to help maintain an orderly market, so the current regulatory scheme empowers them to make these types of decisions under certain circumstances.
On the capital front, brokers also have to maintain certain minimums. Remember, if a trader shorts a stock, their broker is responsible to pay their debts if they can’t. Broker solvency is also important for those making long trades because when traders buy a security, they are typically not the recorded owner of that security. Instead, it gets registered in ‘street name,’ meaning the broker is the registered owner on the books of the company whose shares were bought, and the broker in turn holds that security on behalf of the customer. This helps keep the company’s shareholder records cleaner, and also is what facilitates the quick trading of securities in the modern market.
While the broker is supposed to keep client assets segregated from its own assets, in practice that doesn’t always happen. In the event of broker insolvency, customers of most U.S. brokerage firms are protected by SIPC insurance, but only up to certain limits. Because the broker is responsible for the securities they hold on their customer’s behalf, they may at times take actions in order to meet their regulatory requirements or maintain their solvency. Again, none of this is to say that this is the way things should work, but it is currently how things are.
In any case, while trading halts may be common, the way in which this particular trading halt played out is rather unique. Whether the market operators utilized appropriate discretion in this case or not is up for debate, and will certainly be the subject of a coming plethora of lawsuits and regulatory hearings.
What Happens Next?
I don’t know. However, here is a non-exhaustive list of some potential things which we might see unfold: ideologically-motivated traders who are determined to penalize Wall Street might continue to hold GameStop stock indefinitely, regardless of whether they take losses. Perhaps others will continue to hold because they expect the price to keep going up and that they will be able to cash out later. If holding is widespread, it could potentially keep the stock at a high price for the foreseeable future. Furthermore, the buying might continue now that certain trading restrictions are being lifted, meaning that prices could go even higher than they already have.
Or, prices might decline or even collapse. Some traders may try to sell and take their gains while they can, which would put downward pressure on the price. If that happens on a wide scale, those holding intending to cash out at a higher price later may not be able to if demand drops and they can’t find a buyer for their positions.
And that’s to say nothing of what may happen with other securities or asset classes if something like this happens again. For better or worse, this monumental event will likely have lasting ramifications which reshape the market as we know it. Time will tell what that ultimately looks like.
This article was originally published on Medium on January 31, 2021.