Hedge funds are a unique and often misunderstood part of the financial world, known for their sophisticated investment strategies and the allure of
30 June, 2021
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After the Corona pandemic, the Netherlands seems to be facing a new pandemic in the past year: Many are engaged in investing these days, and especially young adults have taken up investing in the past year [1].
Where does this popularity come from?
The growing popularity of investing can be explained by a number of factors. First of all, the corona pandemic, which caused many holidays and trips to be cancelled, meant the money that was normally spent on this suddenly no longer had any purpose. With a sudden surplus of money and time, a new purpose had to be found. Given the current savings rate, putting the money in your bank account is not an option, and the continuous rise of stock exchange prices such as the AEX makes investing thé alternative where returns can be achieved. Besides these macroeconomic trends, the new influx of investors is largely due to the clever way in which the popular investment apps turn investing into a game. This gamification, as it is called, is the addition of game-like elements to the apps’ interfaces. Examples are the (now removed) confetti in the Robinhood app on every executed trade, the frequent use of emoji’s in the user interface, and rewarding users when executing trades.
Behind the gamification, however, is a financial interest that novice investors do not always see. Neo-brokers such as Robin Hood and Etoro advertise the revolutionary commission-free trading. Whereas in the days of traditional trading floors investors paid a commission for executing a trade, Robinhood, among others, claim that stock trading in their app is free. It is indeed true that these trading platforms do not charge brokerage commissions, but that does not mean the trades are completely free.
What investors often do not know is that the business model of American neo-brokers is based on ‘payment for order flow’, whereby they essentially sell the rights to settle transactions to market makers. A market maker ensures that there are continuous bid and offer prices in a fund, ETF or share by offering or wanting to buy large quantities. Although market makers promote liquidity of a stock, they earn from the difference between the bid and the offer price and are not obliged to offer buyers the lowest possible share price or to give investors the most for their shares. For investors, this means that they do not pay transaction costs, but usually pay a higher price for a share than its actual value.
Neo-brokers thus do not charge direct transaction costs, but still have an interest in a high volume of trading. In addition, payment-for-order flow prices for options are much more lucrative than for normal shares. Of the $180 million Robinhood earned in payment for order flow in the second quarter of 2020, more than $111 million came from option sales [2]. This leads to a conflict of interest, as Robinhood has a financial interest in having its investors trade options, which entails more risk than regular stock trading, while Robinhood’s user base consists mainly of inexperienced investors.
Meme-stocks
A phenomenon which, like the gamification of the stock market, increases the risk taken by (inexperienced) investors, is the emergence of ‘meme-stocks’. This involves small investors trying to thwart institutional investors by buying up the shares on which institutional investors have a short position on a massive scale, causing the price to rise instead of fall. This phenomenon started earlier this year with Gamestop shares, when users of the Reddit page r/wallstreetbets bought up shares of the ailing GameStop chain, and the price skyrocketed exponentially, forcing hedge funds that had short positions on Gamestop to withdraw, known among traders as a “short squeeze”. This led to an extremely volatile price, after which the Gamestop share almost collapsed at the end of January as institutional investors abandoned their short positions (taking their losses).
In recent months, the price of a Gamestop share continued to fluctuate wildly and, following Gamestop, other shares such as AMC, Blackberry, and Wendy’s also experienced meme-stock virality and volatile price movements. For example, AMC’s stock has risen 2,500% on a year-to-date basis, and Blackberry has fluctuated between €8 and €25 since the beginning of 2021. Often, these meme-stocks follow similar price movements. In the early adopter phase, a small number of investors believe that a particular stock is undervalued or suspect that hedge funds are going short on a particular stock and start buying it in large quantities. Next, observant investors step in as they notice the increase in volume and the price of the stock starts to rise. In the late phase, users who have already bought the share encourage other users on online forums to buy it too. The fear of missing out, also known as FOMO, increases, and more and more small investors join in, causing the stock to rise at an unprecedented rate. Usually, after a few days, the hype and value increase reaches its peak, and early adopters start cashing in. Similar to the FOMO buying phase, a chain reaction occurs because people are afraid of losing money. Because meme-stock prices are largely determined by share sentiment on social media forums, the peaks are almost always followed by inevitable crashes (when panic sets in) that are difficult to predict. But, if you can get in early enough, and predict the peak based on social media behaviour, there is a chance you can find a high return on your investment.
“The new generation of investors therefore invests fundamentally differently from traditional investors.”
A website that anticipates on timing the peak of meme-stocks and the investment strategies based on this is memestocks.org [3], a website that keeps track of the number of times certain stocks are mentioned in posts on r/wallstreetbets on a daily basis. However, the website does include a disclaimer that users who use this data for investment purposes are admitting to having an “intellectual deficit, as no one should use memes for investment advice”.
The volatile nature of meme-stocks and their sensitivity to possible market manipulation has logically not gone unnoticed to the SEC, the US regulator of various stock exchanges. Under the leadership of the recently appointed chairman Gary Gensler, the SEC started an investigation into Gamestock’s trading practices [4]. In addition, Gensler suggested an inspection into several meme-stocks as part of a broader investigation into the market structure. Furthermore, Gensler expressed concern about the gamification of the stock market and warned of the consequences: “If we don’t tackle this now, investors, pension savers and education may bear the burden later.” Hence, market regulation is certainly a possible scenario, although it is currently unclear how this will be shaped.
Until then, increased volatility will continue and inexperienced investors will continue to take more risks. This is particularly worrying as investors in the Netherlands increasingly regard themselves as above-average investors [5]. The new generation of investors therefore invests fundamentally differently from traditional investors. Traditional investors generally believe that investing with real money is not a game and try to avoid risks as much as possible. The new generation of investors, on the other hand, are risk-seeking and approach stock trading with a casino mentality, out of which they gain enjoyment. Notwithstanding the enjoyment it may provide, some of the people engaging in these risky investing approaches will definitely gain large amounts while others will see their investments vanish.
