Recent events have shown the increasing influence of retail investors, although long-term financial success will continue to depend on making the right fundamental calls, argues Peter Fitzgerald.
Relying on gut instinct and lacking financial acumen, retail investors have been derided for buying and selling investments at the worst possible moment. No longer.
A so-called ‘democratisation’ of finance could have significant long-term implications
It was always an exaggeration to suggest investor types could be neatly categorised into ‘dumb’ and ‘smart’ money. Recent events – like GameStop – suggest the caricature may need to be redrawn entirely. A so-called ‘democratisation’ of finance, driven by cheap, frictionless trading platforms as well as a surge in free time, could have significant long-term implications.
The massive bull market in cryptocurrencies that began in 2017 was one of the earliest and most notable examples of a market trend led by retail investors. It wasn’t until 2020 that mainstream institutional investors began to take part. Digital currency asset manager Grayscale saw its assets under management surged from $2 billion to $20.2 billion last year. Institutional investors were responsible for 93 per cent of capital inflows in the fourth quarter.1
Then, when equity markets sold off in the spring of 2020, retail investors were quick to pick the bottom of the market.2 Whereas many professional investors fretted over the economic damage being unleashed by the pandemic, it was as if retail investors had seen the movie before. They quickly, and correctly, took a view that central banks and governments would pull out all the stops to come to the rescue of their economies, and financial markets.
Retail investors accounted for as much as a quarter of US stock market activity in the first half of 2020
Their size in the market is now notable, too. Retail investors accounted for as much as a quarter of US stock market activity in the first half of 2020, up from just ten per cent in 2019, according to the head of one US market maker.3
When US car-hire company Hertz filed for bankruptcy protection in May 2020, its shares collapsed to 56 cents, having been above $20 in February. In less than a fortnight after the bankruptcy filing, they had risen tenfold thanks to speculative buying from day traders.4
Retail investors’ ability to shape events was perhaps even more vividly illustrated in January this year, when a $13 billion hedge fund, Melvin Capital, was left with huge losses after amateur investors, coordinating via part of the Reddit social news aggregation and discussion website, pumped up the share price of troubled video-game retailer GameStop more than twentyfold.5
Participants on ‘WallStreetBets’, a forum where participants discuss stock and option trading, piled into GameStop with the aim of pushing up the share price to inflict losses on Melvin Capital and other short sellers. The move, known as a short squeeze, saw GameStop’s shares surge from a little over $17 at the start of the year to almost $350 on January 27.6 Data analytics company S3 reported hedge funds and other investors that bet against GameStop collectively lost nearly $20 billion.7
Retail investors on Reddit soon set their sights on other heavily shorted shares
Having successfully targeted GameStop, retail investors on Reddit soon set their sights on other heavily shorted shares, such as hard-hit cinema group AMC Entertainment, cable TV group ViacomCBS, and home goods retailer Bed Bath & Beyond. The phenomenon quickly spread to other markets, with shares in Canadian technology firm BlackBerry, Finnish telecoms group Nokia, German pharmaceuticals company Evotec, and British publishing company Pearson, all rallying sharply. Silver also came under pressure.
Beware of shorting stocks
The new-found heft of retail investors has important implications for professional investors. This includes those holding relative-value positions, where shares are bought in a basket of stocks investors believe are undervalued, with corresponding short positions held in a different basket of stocks that look relatively expensive.
The events of earlier in the year mean relative-value investors suddenly need to be more circumspect about the shares they are prepared to go short of. For example, with the number of subscribers to WallStreetBets having risen exponentially this year, it makes sense to monitor what is happening on this and similar message forums.8
We now screen for a wider set of metrics prior to taking out short positions
In our multi-strategy portfolios, we now screen for a wider set of metrics prior to taking out short positions in individual stocks and monitor them on an ongoing basis. Particular attention should be paid to daily liquidity in individual stocks, market capitalisation, size of the ‘free float’ and the extent of short positions as a percentage of that free float. Knowing how many trading days it would take to cover outstanding short positions in the stock is also vital.
Few stocks we would look to short are likely to get caught up in this kind of retail trading swarm. As a result, we remain comfortable taking short positions in companies with a large market capitalisation, and whose shares are liquid and easy to borrow, so long as there is a valid investment case. For smaller and less liquid stocks, shorting the relevant index might be a better way of hedging a long position.
A permanent or temporary shift?
The big question is whether the sudden influence of retail investors will persist. There is strong evidence to suggest young people have driven much of the retail activity. Robinhood, for example, says the median age of users of its platform is 31. Apex Clearing, which helps facilitate trades for brokerages, said of the nearly six million accounts it opened in 2020 – a 137 per cent rise on the year before – about one million belonged to Generation Z investors born in the late-1990s or younger, with an average age of 19.9
It also seems likely some of the increased trading has resulted from investors spending their $1200 stimulus cheques, provided to eligible individuals as part of the Coronavirus Aid, Relief and Economic Security (CARES) Act passed in spring 2020. More than half of Robinhood’s new accounts in the first half of 2020 were opened by first-time investors, while the average account size is estimated to be worth no more than $5,000, suggesting those with lower household incomes are investing.10 With an unduly high proportion of this younger cohort having lost their jobs due to the COVID-19 crisis, their interest in trading stocks may fade as they return to full-time employment.
This might mark the start of a more permanent trend
Nevertheless, there are also reasons to believe this might mark the start of a more permanent trend. Up until the 1980s, defined-benefit pensions were the most popular retirement plan offered by employers. But according to the US Bureau of Labor, today only 17 per cent of private-sector workers have access to one. Most companies have shifted workers into defined-contribution plans such as 401(k)s, funded mainly by employees.11
Until now, baby boomers and even the Generation X demographic have been content to hand their pension contributions over to mutual fund managers to run on their behalf. Perhaps the Generation Y or millennial investing class, with access to technology that puts the ability to trade at their fingertips, will be less content to do this.
Moreover, the recent success of retail investors may lead to a permanent rise in the number of people managing their wealth more actively, especially given the extent to which the likes of Robinhood have slashed the cost of trading stocks in recent years. It is worth remembering that as much as 38 per cent of the US equity market is owned by households.12
No short cuts
However, although retail investors might appear to have the upper hand at present, aided by ultra-loose monetary policy and fiscal largesse, they might want to bear in mind there is no shortcut to financial success.
Some individuals, either through luck or judgement, may have made sizeable returns having bought and sold Hertz and GameStop shares at the right times. But latecomers hoping to ride the wave will not have been so lucky. Hertz' share price is currently languishing at $1.20, while GameStop shares are worth less than half January’s high.13
In both cases, this was thanks to the actions of the ultimate short seller: the company itself. Hertz in June 2020 tried to sell $500 million in common stock. In the same regulatory filing, it admitted the shares were probably worthless.14 As for GameStop, its shares sank after it said it planned to sell $1 billion in stock.15
Long-term financial success will continue to depend on selecting the right stocks relative to an assessment of their fundamental worth
These examples go to show that long-term financial success will continue to depend on selecting the right stocks relative to an assessment of their fundamental worth. Taking out short positions will continue to play a role in achieving this goal.
Yet professional investors should also be aware of the power of retail investors as a force, and where necessary adjust their own actions. Since it seems they may not have been quite so naïve after all, it may be time to drop the term ‘dumb money’ for good.