Author: Kurt Spieler, Chief Investment Officer
To understand what's been happening recently with GameStop and other shorted stocks, let’s begin with an explanation of what it means to “short” a stock and the risk some hedge funds take at the individual stock level.
When shorting stocks, investors borrow shares of stocks they expect to decline, with the expectation that they will be able to buy the stocks at a lower price in the future. Effectively, they benefit when stocks decline as compared to the normal position of buying and anticipating price increases—this is referred to as being “long” in a stock.
There is a completely different risk/return profile in being “long” or “short” in a stock. For example, investors who buy $10,000 of a stock risk losing that initial investment but have unlimited upside if the stock appreciates and the investor continues to own the stock. Investors who short $10,000 in the stock have limited upside as the price can’t decline below zero, but unlimited downside as the price could continue to appreciate. Using GameStop as an example, the December 31 price was $18.84 with appreciation to $325.00 on January 29.[i] Over that time, "long” investors might have experienced an appreciation of $162,500 on the $10,000 investment. “Short” investors might have experienced a decline of $162,500 on their investment over the same period.
In the past year, retail investors have added brokerage accounts at an unprecedented rate and actively traded their accounts. Many attribute this trend to a number of online brokers now offering commission-free trading accounts. Day traders, mobilized in online chatrooms, have invested in stocks that have high short positions. These online forums have made it easier to mobilize, swap information and collectively trade stocks. Their goal seems to be to create a surge in the stock price and force short investors to abandon their short positions and buy the stock. This buying can send the stock price even higher, creating a worse outcome for short investors.
GameStop, with its future uncertain due to a rise in e-commerce and the global pandemic, has been one of the most heavily shorted stocks in the U.S. market[ii]. As illustrated over the last two years, GameStop’s short interest as a percentage of free float has ranged from 58% in January 2019 to 134% in October 2020. It’s important to note that it’s highly unusual to have short interest above the free float. The average small cap company is around 6%.[iii]
The extreme level of short interest in the company and its subsequent stock price gain has put pressure on hedge funds, as some have closed out their short positions and sought emergency financing.
One outcome of the trading activity in heavily shorted small stocks is the increase in overall market volatility. The CBOE Volatility Index, or VIX, closed January at 33.09, up from 22.75 at the end of last year.[iv] The rise in the VIX suggests both increased risk aversion and likely selling by hedge funds in other stocks. To close out shorts amid rising prices, some funds were forced to sell shares of companies they liked to maintain their market exposure.
The most shorted stocks in the Russell 2000 (small caps) have widely outperformed the least shorted stocks since October, according to Societe Generale.[v] This has likely driven some of these stocks to prices well above reasonable valuations. Inflated prices typically attract sellers, usually long-term holders of the stock or the companies themselves. In any speculative environment, buying and selling early will likely result in a better investment outcome as compared to buying and selling late.
Our fundamental investment approach involves an emphasis on high-quality companies with strong business models. These firms tend to have solid balance sheets and may be in the growth and expansion stage of business development. Investing in stable companies and paying reasonable valuations will likely lead to portfolio growth. Speculative investing often involves investing in companies with weak fundamentals that are either in the startup or decline stage of their business cycle, and may maintain high levels of debt. In either case, if the company succeeds, the value may soar. Alternatively, the business may not survive. We believe the emphasis of our equity team in building fundamental portfolios increases the probability of long-term investment success.
As we construct portfolios, we constantly research alternative investments to diversify risk. Our alternative allocation provides a return and risk profile that is different from equities or bonds. We do not recommend hedge funds in portfolios for the following reasons:
We primarily implement our alternative exposure through a hedged equity mutual fund that provides participation in U.S. equities while offering some downside market protection. The mutual fund uses options and futures on the S&P 500 (large caps) to hedge risk and does not short individual stocks. The institutional expense ratio of 0.35% is attractive relative to the Morningstar liquid alternative category. This fund exceeded expectations during the 2020 stock market downturn and recovery and has produced superior risk-adjusted returns since its inception in 2013.
For investors, the surge in volatility and trading volumes presents warning signs for the stock market. Historically, one sign of a market top is when retail investors pile in with leverage. We continue to closely monitor trading and market trends. As a professional investor, we consistently apply our investment philosophy and strive to take advantage of market volatility. As highlighted in our 2021 Outlook, we believe diversification of portfolio assets will be important in the upcoming years.
About the Author
Kurt Spieler is the Chief Investment Officer for First National Bank Wealth Management, where he is responsible for developing and implementing investment strategies. This includes leading the asset allocation, equity, fixed income and manager research committees. In addition, Kurt manages investment portfolios for high net worth and institutional clients.
[i] Yahoo Finance, February 1, 2021
[ii] Highshortinterest.com, January 29, 2021
[iii] Barron's, January 28, 2021
[iv] Yahoo Finance, February 1, 2021
[v] MarketWatch, January 28, 2021
This material is provided for informational purposes only. It does not constitute legal, tax, accounting, investment, insurance or other professional advice. All expressions of opinion are subject to change without notice in reaction to changing market, economic or political conditions. Information contained herein from third parties is obtained from what are considered reliable sources. However, although it is intended to be accurate, its accuracy, completeness or reliability cannot be guaranteed. References and/or links to any third-party materials in no way implies an endorsement or affiliation of any kind with any third party. This material was created as of the date indicated and reflects the author’s views as of that date. Neither the publisher nor any other party assumes any liability for loss or damage due to reliance on this material.
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