How Retail Investors are Burning the Hedge Funds

And why 2021 is the best time to get in on the action

2020 was a pivotal moment. Businesses shut down, markets collapsed, and people had lost their livelihoods.

But not everyone was so unfortunate. Savvy investors took the COVID-19 pandemic as a massive opportunity.

With governments pumping billions of dollars into the economy, large swathes of people, stuck at home, started turning towards free trading platforms to capitalize on a resurgent stock market.

Money could be found everywhere.

If you had invested $1,000 into Tesla at the start of 2020 and then sold a year later, you would have made a sweet 900% profit!

The Rise of Free Trading Platforms

Commission-free trading platforms like RobinHood in the US and Trading212 in the UK changed the investing landscape in 2020.

While already popular, these platforms saw record numbers of people signing up during the pandemic crisis.

They made it incredibly easy to buy and sell shares, something previously out of reach for many due to the transaction fees and complexity associated with older methods.

Even I switched away from my bank's investment account. Why would I pay upwards of £25 to trade on a website with poor UI, when I could access the world's markets for free?

With free apps and stimulus money flowing to every household, many used their windfall to try their hand at the stock market.

It made sense, after all. Interest rates were at an all-time low, making returns from savings accounts practically worthless.

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” — Robert G. Allen

The Markets Shifted Towards the People

We all saw what happened with the Tesla share price in 2020. It led to Elon Musk becoming the richest man in the world.

But how could a loss-making company that had to shut its factories, overtake a highly profitable and well-diversified megalith like Amazon, and go on to become one of the largest market cap companies?

A speculative bubble perhaps?

Even as the price shot past $300, then $400, traditional analysts and institutional investors began calling the stock overvalued. But then it doubled again and showed no signs of stopping.

There was no major news that could have propelled this to such heights. New Tesla models were being made sure, but this would not have been enough to triple the stock price.

Retail Investors Had Influence

Small-cap and ‘penny stocks’ could easily be influenced by individuals. Seeing gains of 50% was impressive, but not when you consider the stock price had gone from $1 to $1.50.

But the sharp movements weren’t just happening to small-caps anymore. Large, well-known brands started being affected as well.

The ‘old guard’ was proven wrong, and no amount of persuading would shift the minds of thousands who were raking in the money.

It wasn’t just Tesla. Vaccine stocks, shares in clean energy, and electric vehicle companies also started exploding. It wasn’t uncommon to wake up and see a stock going up by 20, 50, or even 100%.

With gains like that daily, why would anyone keep their funds in a savings account or slow-moving ETF?

As the profits increased, so did the trading volume. It would only be a matter of time before retail investors started overtaking hedge funds and their billions.

The Fight for GameStop

There had always been a question about the ethics of institutional investors. While they represented people of all backgrounds, their exclusivity meant that their clients were primarily the rich and elite.

Millionaires handing money to other millionaires left a sour taste in many who saw these groups as greedy and manipulative, aiming to bring down honest companies for their own gain.

One of the tactics used by these institutional investors would be the concept of ‘shorting’. Essentially, investors would borrow a stock and sell it immediately, to rebuy at a lower price and keep the profits.

By doing this, the stock price would drop massively, making future shares cheaper to buyback.

One company that was heavily shorted in this way was GameStop.

Bring in r/WallStreetBets

In late 2020, a seemingly obscure community of individuals on a subreddit started discussing GameStop’s potential.

The store had come under new management, yet the share price was oddly very low.

Research by some of these individuals led to the discovery of a certain hedge fund called ‘Melvin Capital’ that had shorted GameStop to the tune of billions.

The profits were staggering, but they continued to hold on to their shorts despite the all-time low of GameStop’s share price.

It didn’t take long to turn this hedge fund into an enemy of the common man. Over a period of just a few weeks, memes and posts about fighting Melvin and restoring GameStop started to make waves.

Of course, this also meant free money could be made for anyone willing to bet against the institutions. If everyone brought shares in GameStop, it would increase the price forcing hedge funds including Melvin Capital to capitulate.

Sure enough, huge sums were poured into the company. Some threw in small amounts, while others invested 5 and even 6 figures, swearing to never sell until Melvin Capital was made bankrupt.

The price surged and defied analyst expectations who could not explain why the stock was rising at such a rapid rate.

Within a few weeks, Melvin Capital was forced to borrow almost $3 billion just to maintain their positions.

While the fight was far from over, did the common man really manage to beat a hedge fund?

The Aftermath

The meteoric rise of GameStop made headlines. There was no explanation for why the share price increased from a mere $4 to over $300.

While analysts continued to argue that the stock was overvalued, they failed to realise that the same had happened with Tesla a mere 6 months earlier.

They were no longer the only ones that could influence the market. They now had to share it with the common man.

Eyes started turning towards other shorted companies. Newspapers and journalists began drawing up lists of ‘future GME stocks’ as if they, too, wanted to join in on the hedge fund hunt.

As for r/WallStreetBets? Well, the unsurprising attention caused the number of followers to swell from 1.6 million in December to over 3 million a month later.

It’s hard to tell whether regulations would come in as a result of the surges, but are these investors wrong?

Market makers and hedge funds had been doing this type of manipulation for decades. Now that they are the victims, should we really side with them?

I don’t think so.