Financing

How Institutional Investors and Individuals Were Tripped Up by the GameStop Saga

Several professional money managers were caught unawares in early 2021 by the sudden run-up in the price of GameStop stock. When the dust settled, the hedge funds that they managed lost an aggregate of billions of dollars when they were forced to purchase the price-inflated shares to cover short large positions that they held in GameStop.

Hedge funds generally do not draw any sympathy in the investment community, and many individual investors expressed a degree of satisfaction over the comeuppance that those funds experienced. Nonetheless, all investors would do well to analyze the circumstances that catalyzed the GameStop saga and the subsequent calls from different sectors of the investment industry for new regulations to prevent similar events. The reality is that while hedge funds lost money, thousands of small investors also lost substantial value in their portfolios as they attempted to ride the GameStop wave long after the market had already absorbed its effects.

What Happened to GameStop’s stock price?

GameStop owns and operates hundreds of brick-and-mortar stores that sell video games. Its stock was trading at $3.25 per share in September 2020 when a professional investor bought a 13% interest in the company and began urging the company to transition its business to an online model.

GameStop and other companies like it have long been targets of institutional investors that hold large short-sale positions in their stock. Short-sellers borrow shares that they then sell in the open market with the expectation that the company’s share price will decline, thus allowing them to repurchase the borrowed shares at a lower price. Short selling is a legitimate investment strategy that contributes to the efficiency of the markets by improving liquidity and overall trading volume.

Hedge funds and other institutional investors perceived a significant short sale opportunity as GameStop announced plans to close more than 450 of its stores. Within a short period, total short interest positions in GameStop stock rose to more than 70 million shares. Simultaneously, the company caught the attention of individual investors on a popular social media platform. Those investors went on a GameStop buying frenzy with an online app that enabled them to make commission-free purchases of GameStop shares. By the end of January 2021, GameStop’s share price had risen to more than $140 per share. GameStop’s share price experienced high volatility in the first half of the year, often increasing or decreasing by 50% to 90% in a single trading day. The stock continues to trade at or near $150 per share at the midway point of 2021.

The institutional investors that bet against GameStop were caught in a short squeeze, in which they were forced to purchase shares at what might have been an artificially inflated price in order to deliver borrowed shares back to their original owner. Many individual investors lost money when they purchased GameStop shares at high prices but then sold in a panicked frenzy when the share price dropped precipitously over the course of one or two trading days.

What has been the response to the GameStop saga?

Responses and critiques to the GameStop saga came in three broad waves. The first wave came from the hedge funds and online trading apps that were on the front lines of the GameStop share price volatility. Hedge fund criticism forced a trading app to temporarily halt trading in GameStop stock. Shares of the stock continued to be traded, but not through the app that was the primary vehicle used by individual investors. That trading halt served to convey an impression that the markets were skewed against individual investors, and it was subsequently lifted to allow users of the app to continue trading.

The second wave came from academics and retail brokers, all of whom offered different opinions and recommendations on what catalyzed the saga and how similar events could be prevented in the future. The inevitable third wave began with hearings, testimony, and analysis from representatives of the United States Securities and Exchange Commission, the Financial Industry Regulatory Authority (FINRA), and the Depository Trust and Clearing Corporation. The hearings initially targeted hedge funds that were perceived as participating in predatory short selling. The focus then shifted to the intersection of finance and technology, and particularly the new digital trading applications that give individual investors low- or no-cost access to the markets.

The regulatory bodies focused their observations on the desirability of improving disclosures of short interest and the related activities that support short sales. In response to criticism that short sale strategies are divorced from a company’s fundamental value, the SEC responded that short sales activities have been part of the markets since their inception. The SEC has the authority to adopt rules and regulations to ensure that the markets are fair, orderly, and efficient, and free from fraud and manipulation. New regulations to improve the transparency of short sales activities will contribute to this mission, and it is likely that the SEC and other regulatory bodies will develop and adopt new disclosure regulations over the next 12 to 24 months.

How can individual investors benefit from the GameStop Saga?

Many individual investors who lost value in the GameStop saga were likely reacting to market events from an emotional perspective and were not following a fully-formed wealth creation and management strategy for investments in their portfolios. The meteoric rise in GameStop’s share price certainly presented an ad hoc opportunity for intelligent investors that devoted a portion of their portfolios to tactical investment opportunities. The investors that made mistakes were those who shifted a major portion of their investment dollars into GameStop stock, essentially wagering that the stock price would continue to climb and that they could get out of their positions in time to profit from that rise.

The information disclosure principles that are the foundation for all modern stock exchanges continue to make them the most transparent and efficient place for an investor to increase the value of his or her portfolio. Outlying events like the GameStop saga will continue to occur as long as the evolution of finance lags the growth of technology. Investors can accommodate these events with wealth management plans that include strategic and tactical components that maintain core value with a potential to invest a limited portion of their portfolio into one-time opportunities as they arise.