Many of us are following how a group of retail investors bought stock that halted trades on some brokerage firms, may bankrupt a hedge fund, and got Wall Street’s attention.
In case you missed it, here’s a quick overview: Members of the Reddit group Wall Street Bets decided to go all in when they saw that Gamestop stocks were shorted — which is borrowing a stock, selling it, and betting you can buy it again at a lower price to make money before you have to return it — by 140 percent thanks to the hedge fund Melvin Capital. The Internet reacted with memes. It dominated business news everywhere. But it’s more than a headline: It’s a serious disruption to the market.
The finance world is watching this unfold. And there are many questions that everyone is asking — from the average person to the U.S. Securities and Exchange Commission (SEC).
With decades of experience in corporate finance and treasury, Finance Lecturer Nick Vlisides, who teaches UM-Dearborn’s Investment Fund Management course, weighs in on what this says about hedge funds, buyer behavior and the stock market.
Nick Vlisides: I understand where this is coming from. Hedge funds can be very large and have a great deal of capital to help protect and insulate them from market volatility. And there is something almost mythological about a small group of individual investors banding together to take on or oppose a hedge fund position.
Jack Bogle, who founded the Vanguard Group nearly 50 years ago, is said to have begun the process of “democratizing” markets by allowing smaller investors to pool funds and leverage their combined resources to influence market positions. There have been several studies that also advance the notion that the markets have over the past several decades become more influenced by the large corporate and professional investment firms. The principle that everyone should be allowed to make investments and not be controlled by a few investment houses is appealing, but has limits. Making positive returns on investments takes a great deal of research and analysis.
Buying and selling stocks is not like betting on the “red” or “black” square at the local casino’s roulette wheel. Our world is becoming increasingly complex and rigorous impartial analysis is critical in making investment decisions.
Vlisides: Hedge fund managers make decisions based on financial analysis looking at earnings, sales trends, cash flows, etc. — that’s what’s termed fundamental analyses. These analysts pour over earnings and financial reports. They examine past trends, look at the strength of management and make educated predictions of how a company will fare over the investment cycle. For instance, GM just announced that they will be going all electric by 2035. Hedge fund managers then evaluate: Can they do it? Do they have the management team in-place that can move the company in that direction? Do they have the capital? What are the forecasted demands for electric vehicles and particularly their products? Because of the level of analysis and the size of the funds they have access to, it can be true that the large hedge funds have weight and they influence certain stocks by buying and selling them.
More often than not, the investment community is honest and works hard for their clients. Mutual funds are built to assist investors to save funds for retirement, education and so forth. Hedge funds can take on a higher risk approach. They are sometimes required by their investment policies to make returns greater than market indexes and/or to make positive returns when the markets fall. They do this by buying commodities such as gold, oil, livestock, currencies and by shorting stocks.
Vlisides: As investors buy/sell stocks, cash must be moved from one bank account to another bank account and that takes time. It takes two days to have funds “clear” markets (through the Depository Trust & Clearing Corporation) and to complete investment transactions. During those two days, brokerage firms and hedge funds must cover those positions with their own funds which can reach into the billions of dollars. Robinhood did not have the funds to cover or withstand the billions of dollars required for the two-day clearing period and was forced to shut-down trading in certain stocks. This rule is required for all such firms and brokerages. It is important for brokerage firms to know their clients and to ensure that they have the capital to cover that clearing period. Robinhood was at fault for not being upfront with its clients. It appears that they were caught off-guard and did not explain their position until after they closed trading in these stocks. They could have, and should have, been more transparent about their actions, this may have helped to avoid the negative response to their temporary trading restrictions.
Vlisides: Laws and regulations are in place that restrict hedge funds and other investment firms from collusion and there are stiff penalties for violations. Some people are making the argument that this social platform activity is a form of collusion that was not anticipated by regulators. It’s not clear what can be done, but these recent actions have an impact on the concept of free and fair trade in the equity markets.
The second concern is the arbitrary and capricious nature of the investment targets. Why support Gamestop, but not Thunderful? Why AMC, but not The Cineplex Group? Or, more recently, why silver, but not copper? These actions are based on an arbitrary choice of what appears to be a few individuals serving as a catalyst to others who follow — not based on disciplined research and analysis.
On the one hand, it is interesting to witness how the actions of individuals can collectively impact certain targeted securities while conversely negatively impacting parts of the professional investment community. Overall, shocks to the markets can be therapeutic providing a renewed focus on investment firms methods of valuation.
Vlisides: It is always a good thing for people to learn more about the financial markets. Investing funds into stocks and other securities requires research and study. We are definitely talking about this in class — it’s important for our students to learn the intricate and sometimes delicate workings of the financial markets. While it is interesting to observe and learn about the behavioral effects of a collective flash surge in trading activity, it’s also important to note that nothing can replace hard work and study when it comes to making investment decisions.
