How is it that the most shorted stocks—or the most bet-against—have generated some of the highest year-to-date returns in 2021?
Thanks to millions of Reddit users who congregated in forums like r/WallStreetBets that are dedicated to conjuring up trading ideas, an army of individual investors has formed to buy highly shorted names like GameStop, AMC, and Bed Bath & Beyond en masse. (We recommend following Charlie Bilello’s running Twitter thread on the topic.)
The upward momentum created a short squeeze and has forced short-sellers like Melvin Capital, Citron, and other hedge funds to buy shares rapidly, sending prices sky high and also triggering brokerages to step in with questionable actions and motives.
Here’s what advisors may want to communicate to their prospects and clients about the events taking place:
Short Squeezes Don’t Last Forever – And This Too Shall Pass
Though the origins of this short squeeze are unique in nature, it certainly isn’t the first to have ever occurred. Both Volkswagen and Tilray were subjected to massive short squeezes in years prior:
…and in both cases, what went way up came crashing way down. Tilray’s all-time returns peaked at a gigantic 856% after its IPO, but that was cut in more than half over the next three trading days. Similarly, GameStop and AMC both fell over 50% from their short-squeeze highs, but doing so in just the next trading day.
Tilray continued on a consistent but steep decline and still trades at prices about 25% below its IPO price. By comparison, the S&P 500 has grown 33% in the time since Tilray’s IPO.
High Rewards Carry High Risks
GameStop shares soared 125% in a single trading session, an astonishing surge that understandably captured everyone’s attention. For perspective, it took the S&P 500 nearly seven and a half years to grow its latest 125%.
But was one day of glory worth it? And should GameStop be on any long-term investor’s radar? Anyone holding GameStop before the last month would have endured years of negative returns, and now weeks of unprecedented volatility, where both equity indices and fixed income instead experienced a long bull run.
Owning other highly-shorted names, like Bed Bath & Beyond, wouldn’t have gone much better. Despite that 31.5% jump on January 27th, long term investors in Bed Bath & Beyond lost as much as 95% in that same seven and a half year span.
While doubling an investment in a day might sound great, fundamentally unsound names like GameStop came with years of declining performances. Other vehicles such as equity indices and treasury bonds proved to be steady wealth building tools with very low volatility, even through turbulent market conditions (re: COVID-19 in Spring 2020).
Funds and ETFs Get Significantly Impacted
When one or a few holdings of a market capitalization-weighted fund or ETF experiences a big move, its managers must buy or sell large quantities of shares to match that shift in market cap.
ETFs that have exposure to GameStop were forced to buy massive amounts of the stock to reflect that shift. The SPDR S&P Retail ETF (XRT) increased its GameStop exposure to an astonishing 13.5X that of its next highest holding as of January 31st, for example. And it wasn’t just retail ETFs that were affected, as shown in the table here:
Big moves in a single holding can drastically alter a fund’s weight, whether fundholders want it that way or not. Additionally, such a disproportionate change in one holding’s value can drastically skew the performance of the overall fund. As a result, the overall performances of ETFs with high exposure to GameStop will largely depend on GME’s future, whatever it may hold.
The Bottom Line
Chasing after astronomical but short-lived returns in low-quality securities can feel a lot like chasing the wind – and the wind can disappear just as quickly as it came. It’s unknown when the dust will finally settle on this short squeeze, but there remains a plethora of ways for your clients to build wealth long-term while sleeping well at night.
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