Building upon what my colleague, Mark Wood, covered in an earlier blog post, I wanted to examine the long-term issues exposed by GameStop’s boom-and-bust experience, all but one of which seem relatively small or manageable within the current regulatory framework. While short squeezes of the sort that happened with GameStop are not new or unforeseeable, the SEC has been given a stark reminder of its 2010 mandate to enable more transparency of short-selling exposures in U.S. markets. Another issue raised during this saga is that the systemic risk of unsettled trades, which forced the online brokerage Robinhood to suspend client trading, can be reduced with trade settlement periods moving from T+2 days to T+1.
However, a bigger issue highlighted by GameStop, which will be more difficult to resolve, is the unintended consequences of zero-cost money and commission-free trading enabled by today’s highly stimulative monetary and fiscal policies. Bubbles forming and popping will likely be a common feature across markets.
As Warren Buffett astutely noted, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.” Given Melvin Capital’s 53% loss in January at the hands of Robinhood traders, is the broader cadre of hedge funds and their short-selling techniques at risk of now being the patsy? With the short-selling issues highlighted in this experience, I outlined the following risk-management questions that institutional investors can ask their hedge fund managers in the wake of this match-up between supposed smart money and mob money:
- What measures do you use to quantitatively gauge the level of crowding in individual short stock positions (e.g., short interest as percent of the stock’s float, short interest as percent of the stock’s average daily volume, cost of borrowing stock)? And how frequently do those measures get updated?
- Since crowds love a story, how do you qualitatively assess your book of shorts to minimize the risk of any one becoming a meme stock like GameStop?
- Although crowding is normally helpful—indeed needed—for early movers on a stock, how do you distinguish between an increasingly crowded trade that is generating profits versus a profitable trade that has become too crowded, long or short?
- What are the investment guidelines for managing the risks of the short portfolio in terms of position sizing, number of positions, and industry diversification? Are those guidelines monitored and enforced by a risk management team, an investment committee, or the individual portfolio manager?
- How much alpha did your short portfolio generate versus your long portfolio? For short exposure, how often do you use ETFs versus individual stocks? To express a bearish view on a company’s stock, do you prefer to use put options versus stock-based shorts? And why?
For a fuller discussion of the issues raised during the GameStop saga, please refer to my most recent Hedge Fund Monitor, accessible through the button below.