By Nuno Fernandes, Full Professor of Finance at IESE Business School and the author of “The Value Killers. How Mergers and Acquisitions Cost Companies Billions—And How to Prevent It” and Finance for Executives: A Practical Guide for Managers
Last week, the biggest news on capital markets related to the Reddit-led group of small investors (individually small, but several hundreds of thousand, or even millions) that short-squeezed some large hedge funds, and led to skyrocketing stock prices in companies like Gamestop, Blackberry, or American Airlines, all of which are struggling in their respective real businesses ....
There is nothing wrong with retail investors profiting in billions while hedge funds lose billions. However, before joining the bandwagon, it is important that investors understand what they are doing and how deep their pockets are. In addition, this brings important challenges for regulators, in particular, in monitoring the business model of some popular trading outlets that may indeed be hurting investors.
This is not new
What we saw last week with Blackberry, Nokia, Gamestop, and other stocks is not very new. It has all the features of a scheme called pump and dump. In this scheme, somebody buys an asset, and then promotes it through different actions in order to have more people buying into that asset.
As soon as the buying trend is in place, the prices go up. Moreover, those early investors, who started the frenzy, can then sell their shares at an inflated price.
It is not new…. we have seen this during the dot-com crisis of the late 90s. We have seen this in the global financial crisis of 2008. And we have seen this in different markets, for instance, in real estate. A few years ago, you could buy a house in Dubai with less than 5% down payment. Then you would resell it after 6 months. In case the price had moved up by just 5%, your return would be 100% ... However, this debt-fueled, real estate bubble ended badly. Dubai had to be rescued by its neighbor Abu Dhabi, thousands of small investors lost significant amounts of money, and many of these houses remain empty today. It is important to remember that leverage boosts your returns, but also your losses.
The problem is that most retail investors have a short memory. And because most have not been investing for a long time, they do not remember history, and its lessons.
Hedge funds do indeed have short positions in many of these stocks—and the short squeeze is creating problems for them. However, the dangers of short selling are always related to your wealth constraints. If you are right, but do not have deep pockets, you may be forced to close your position before the price moves down. This is, for instance, what happened to LTCM, a famous hedge fund that went bust in the late 1990s. However, if you have access to liquidity, to comply with margin calls, etc., then you can simply wait for the noise to pass.
As for retail investors, they are gambling. This is not investing. The behaviors we observed last week are similar to those seen in betting in football, horseracing, or roulette. Not rational, but highly emotional herd behaviors.
Robinhood: democratizing finance, or hurting unsophisticated investors?
Finally, a word on regulation. Regulators should watch this very carefully. Indeed, underlying what seems to be a simple blog on the Internet can be a serious fraud scheme and attempt to manipulate the market for personal profit. Indeed, trying to preempt the market; leading others to buy in a herd; and inflating the price, then selling, and leaving the party before it crashes should be clearly investigated. In addition, this whole debacle hides an even more important problem, which is how to deal with new business models in trading, such as those used by Robinhood.
Retail investors are sometimes referred to in the academic literature as noise traders, or liquidity providers. Indeed, that is the typical pattern of retail investors. They are uninformed, and thus provide liquidity to capital markets, by buying and selling all the time. Liquidity itself is valued positively and can be a source of profits. That is why recently some new players, such as the stock trading app Robinhood, started with new business models targeting retail individuals. In particular, Robinhood has accounts that charge 0% fee on all stocks traded.
How can a broker make money, if it doesn’t charge fees on the trades that you execute? When someone gives you something for free, that should raise your awareness. It is true that individual investors are able to trade without being charged any formal commission. However, it is also true that the business model of Robin Hood demands caution.
The data show how the company generates significant income from payments for order flow, as well as other sources: selling user data (namely, the order flow, to large institutional players), stock loans (including to those who want to short-sell the shares), and rebates from market makers and trading venues.
This company has already been fined for not serving their clients transparently, and for not providing them the best prices. In December 2019, FINRA fined Robinhood for failing to direct trades so that its customers received the best prices. In 2020, Robinhood agreed a $65 million settlement with the US SEC after failing to deliver value for clients. They were accused of having “gamification strategies to manipulate customers,” and, according to the SEC, to provide inferior pricing on its customers’ orders.
David vs Goliath
In the fight of David versus Goliath, in financial markets, usually it is Goliath who wins.
When people on the street, without any financial knowledge, start bragging about their investment skills, and how they are making money on the stock exchange, I always get worried that we are in the next bubble. And we have to remember that sometimes there are deep pockets behind some short positions…. which may mean very negative returns to those retail investors who simply follow the Reddit blog blindly.
In the end, in financial markets (as in politics), we have to be careful about populist players who bend the rules, who spout nice words, but conceal their business model. In improving the world’s financial literacy, the last thing we need is to push for risky investment strategies like day trading.
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February 04, 2021 at 01:34PM
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What Gamestop Tells Us About Shady Business Models - Forbes
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