On January 27, 2021, members of a subreddit called r/WallStreetBets– an online forum group of over 2 million amateur investors, initiated a historic and unusual event in the marketplace: a short squeeze that caused major losses for short sellers and hedge funds. One of the hedge funds most impacted and was bailed out by Point72 and Citadel was Melvin Capital. Founded and owned by Gabriel Plotkin, Melvin Capital is a major hedge fund that reportedly had $8 billion in assets under management in January 2021 and primarily invests in tech and consumer stocks.
Shorting, an investment strategy that speculates on the decline in a stock or security’s price, is a riskier strategy used by advanced traders that can either be quite rewarding or detrimental. The process involves an investor borrowing shares of stock they believe will decline in value in the future and then turning around to sell them at market price to someone else. Eventually, the borrowed stocks must be returned, and the investor hopes to repurchase the stocks at a lower price to generate a profit. However, if the price of the shorted stock rises, short sellers are forced to cover their shorts by buying more shorts to attempt to suppress the stock price. When a stock or other asset jumps sharply higher and forces short sellers to buy stock to cover losses, this is called a short squeeze.
In the case of Melvin Capital, Citron, other hedge funds, and short sellers, GameStop (GME) was prime shorting material. The company had already been in decline and the COVID-19 pandemic was not helping. In fact, Citron even planned a livestream to explain why investing in GME was a terrible idea. However, despite the generally negative perception of the GameStop and its stock, there was a potential that certain investors and the members of r/WallStreetBets saw.
First, Chewy Founder Andrew Cohen and two other Chewy executives were announced to be joining GameStop’s board of directors. This was particularly exciting news considering the capital and e-commerce experience Cohen would bring to GameStop as the company needs to up their online retailing work in light of the pandemic and already declining in-store sales. Secondly, a new console cycle was announced at the end of 2020; this always translated into an increase in sales for GameStop. Third, Microsoft and GameStop signed a lucrative deal in which Microsoft agreed to give GameStop a share of XBox’s digital revenue. These factors all moved in GameStop’s favor and led to an increase in stock price.
Members of the r/WallStreetBets– who generally like GameStop due to its ties to gaming and meme culture– saw these developments and the fact that GME was one of the most shorted stocks as an opportunity. The sheer number of retail investors in the community rivaled the power of major hedge funds on Wall Street, and they realized that if they organized themselves to collectively buy GME and cause a short squeeze. Most importantly, it would send a message to the institutions and hedge funds capitalizing and betting on a business’ downfall: do not mess with us and the market as if we are your toys. Many of the r/WallStreetBets members are of the younger generations and have memories of the financial and market disaster of 2007 and 2008 caused by the institutions on Wall Street.
r/WallStreetBets bought up the GME shares and drove the stock price from opening at $88.56 on the morning of January 26th, to a high of $483 at some point on January 28th. This sudden surge in price forced the short sellers to buy to cover losses. Melvin Capital, which held many short positions, lost an incredible amount of money and absorbed a 53% loss for the month of January. Citron also suffered great losses and after this experience decided to end a 20 year practice of releasing their ”short reports.” In the midst of the frenzy, Robinhood and other trading platforms restricted purchases of GME on January 28th, citing potential problems with clearing firms and capital requirements. This sparked outrage as the platform is meant to be a democratic, “free,” and easy-to-use trading platform for investors of all levels.
Following this, billionaires and executives of the short seller groups came to plead for regulations and denounced the event as a product of cruel market manipulation and insufficient market regulation that would lead to market volatility. Given the unusual event, the SEC has gotten involved and is investigating the actions of the Reddit investors, Robinhood, and the GameStop surge itself. Most recently, the House Financial Services Committee has held a hearing for Robhinhood Co-CEO Vladimir Tenev and Keith Gill, the investor who popularized the GameStop trade on Reddit testified on February 18th.
In reflection of these events, we must understand that the actions of the amateur Reddit investors were not illegal. In fact, their work is a mirror of what happens behind closed doors at large firms with lots of capital, except it was on a public internet forum and the amateur investors had no secret information that guided their decision-making (unless further investigation shows otherwise). Whether this can be deemed as a case of “market manipulation” is currently under investigation by the SEC and if it is so, the fault lies in the few orchestrators and not in the larger group.
Like all events, this comes with lessons for us. The first lesson: shorting is a dangerous strategy and should not be used by beginners or those thinking to generate long-term, stable returns. State pension funds fall into the latter group and have a fiduciary responsibility to make the right decision with their constituents’ retirement funds. The events of January 27th and 28th should serve as a reminder to never hold all of your eggs in one basket. Though it may have a potential for high reward, it is too risky of a strategy to be betting retirement savings on.
Some of the big investors in hedge funds are the public sector pension funds. The public sector funds allocate some of their funds to other hedge funds to seek returns from alternative strategies or long-shorts. For instance, Melvin Capital’s clients are generally institutions, pension plans, high net worth individuals, and other sophisticated investors. When these hedge funds engage in risky strategies or underperform, this is a direct blow to the hard-working public servants who need the money they were promised. But if the money is not there, then it is not there. It may be wiser for State Pension funds to continue to manage their own portfolios in part due to fiduciary responsibility and to the fact the hedge funds do not really outperform the average investor.
As Melvin Capital sustained great losses, they must find a way to pay their investors back. But how? This dilemma is not unfamiliar for states with pension deficits as they scramble to find ways to close their gaps. It may do them well to watch Melvin Capital work to pay back their investors while also staying away from shorts and keeping a broad and diversified portfolio.
A final lesson from this experience is in looking at what fueled the r/WallStreetBets investors to want to short squeeze the short sellers. The main sentiment was “stick it to the man,” and this comes from a place of pain for the Reddit investors who grew up during the 2007-2008 financial crisis. State pension funds should take note that all generations of a family will remember any failure to act as responsible guardians and deliver the pension funds to their constituents.