On Tuesday, GameStop reported Q4 earnings, its first earnings announcement since the short squeeze. Press and investor focus on the announcement was intense, and many investors were unable to dial into the earnings call, presumably because day traders had filled the line. Significant share price volatility followed the earnings announcement—including a 34% plunge the next day— serving as a reminder that the effects of new shareholder dynamics, including trading dominated by short-term holders, can persist.
The GameStop short squeeze two months ago generated significant questions about market access, short sellers and day traders. But, while these topics are worthy of debate, they fail to address how changes in the equity markets have transformed the way stocks trade and enabled a relatively small group of traders to drive GameStop’s shares to stratospheric heights. While the GameStop situation is an extreme example, the ability of small groups of investors to meaningfully impact a company’s stock price is a fact of life in today’s markets.
Over the past 10 years, the shareholder registers of U.S. public companies have fundamentally changed, which has fundamentally impacted trading and volatility.
Index funds now comprise substantial percentages of the shareholder base of most companies and, given their tendency to hold shares over the long-term, have reduced the shares available for trading. At the same time, actively-managed funds have seen substantial declines in their assets under management. As a result, these “smart money” investors are generally less impactful on day-to-day trading, especially in sectors that they have significantly exited such as oil & gas. Fundamental investors also have few sources of independent insight, as cost dynamics have reduced the number of quality research analysts covering public companies.
So what investors are driving trading – and the stock prices – of public companies?
Quant funds, “retail” investors (largely day traders), options traders and short sellers are now the dominant drivers of trading volumes. Given fewer shares are traded (especially at midcap companies), the ability of these short-term traders to impact stock prices is now substantial.
This thought piece further analyzes these dynamics and the potential impacts on our clients.
The Rise of Index Funds
Index funds now account for more than half of all equity fund holdings in the U.S. They have increased their holdings substantially – index fund holdings have more than doubled over the past decade. This change is transforming the investor relations function, increasing the focus on ESG, board-level engagement and governance issues. Getting shareholder approval of M&A now requires index fund support, requiring important changes to deal-related communications.
The index funds have also impacted trading.[1][2]Index funds do not actively trade stocks — they trade mostly to adjust for company index weightings and fund flows. Compared to traditional long-only investors, index funds have the longest holding periods by a significant margin. Consequently, fewer shares are available for trading by other types of investors.
Quant Funds and Day Traders Now Dominate Trading[3]
Quantitative funds and day-trading retail investors account for significantly more trading volume today, particularly for midcap companies. These investors are significantly more short-term focused. Traditional mutual funds are more likely to focus on the fundamentals of individual stocks, and hold shares through periods of volatility to allow their investment thesis to play out. Quants and day traders are more likely to invest across sectors and change holdings based on macroeconomic news, short-term sector developments and the latest rumors. In short, for some companies, factors that are not directly correlated to company performance can significantly influence short-term trading.
Increased Use of Options and Short Strategies
These fundamental changes in trading have been further amplified by the rise in options trading and short selling. Options volume increased substantially over the past two years.[4] Increased options activity can lead to volatility in underlying share prices, as investors hedge their options positions by buying or selling the underlying stock. In addition, when option holders or short sellers exit their positions, they often do so rapidly. These exits have driven substantial swings in stock prices, which are further exacerbated by related trading by quant funds.
These particular forms of trades are often anonymous as reporting requirements for options and short selling are minimal. Moreover, the loopholes in the 13D and Hart-Scott-Rodino requirements for options enable parties to amass substantial positions via options without any public filings.
These dynamics created a combustible mix that gave rise to GameStop.
What Happened to GameStop?
In recent years, GameStop’s stock had been under significant pressure in light of increasing skepticism about its brick-and-mortar business model. The company’s stock traded between $2.80 and $20.99 from 2019 to 2020, with increasing short interest.
In December 2020, activist investor and former Chewy.com executive Ryan Cohen disclosed a 12.9% stake in GameStop, and was added to the Board along with two other former Chewy.com executives on January 11, 2021. On January 15, 2021, GameStop had the highest short interest of any company in the Russell 3000, with 121% of the float shorted. The immense short interest and perceived opportunity for turnaround, given Cohen’s background at Chewy, attracted attention from Reddit Traders and other investors. As Reddit Traders bought, GameStop shares began to climb and short sellers were forced to close out their positions and deliver shares. The short sellers, mostly hedge funds, were forced to buy shares at any price available (a “short squeeze”) driving the share price to dizzying heights. Quant fund traders also entered into the fray. GameStop was essentially in the middle of a perfect storm driven by today’s trading paradigm.
This dynamic spilled over to the broader market as well. On 1/27/21, 23.7 billion shares were traded across the market, the most in any single trading day in history.[5] Heavily shorted stocks were most impacted – the 10 Russell 3000 stocks with the highest short interest experienced significant share price appreciation on the back of the GameStop events. Short sellers in those companies moved to cover those positions out of fear that they would be targeted by the Reddit Traders. This trading drove the prices of those stocks higher.[6]
How Should Companies Prepare in This Environment?
While it’s unlikely that an escalation the scale of GameStop will be a common occurrence, this sort of single stock vulnerability is likely here to stay, particularly for small and mid-cap public companies that have limited trading float. There are steps companies can take to assess and potentially mitigate this risk:
• Monitor trading – review price changes and volatility, volume traded, short interest, block trades and options trading;
• Know your shareholder base – ensure you know your top institutional investors and understand how their positions change over time;
• Prioritize index fund engagement – index funds will stay in your shareholder base despite increased volatility, unlike most other investors, and will be key decision makers on important shareholder vote topics;
• Engage with existing investors and target new investors – developing relationships with existing shareholders, and targeting long-term fundamental investors will help minimize the influence of quantitative investors and Reddit Traders on share prices;
• Prepare for potential activist and hostile activity – as share price dislocations occur, this could create entry points for potential hostile parties.
[1] Source: Morningstar. Includes U.S. domiciled funds and ETFs; excludes money market funds and fund of funds
[2] Source: Refinitiv. Based on average of top 5 institutions in each respective category by AUM as of latest filings
[3] Quantitative volume defined as market making, high frequency trading and quant funds. Estimates per Bloomberg, Tabb Group, JP Morgan Global Quantitative & Derivatives Strategy research (6/13/17), Financial Times article titled “Volatility: how ‘algos’ changed the rhythm of the market” (1/9/19) and Jefferies Equities White Paper (2019): “When the Market Moves the Market”
[4] Source: FactSet
[5] Source: Bloomberg
[6] Source: FactSet
