Activist investors: a danger to the market or an opportunity for wealth creation?

The GameStop trading frenzy has shown the impact activist investors can have but while some believe this will democratise finance, others are warning of the dangers

There has been a surge in day-trading frenzies, fuelled by the actions of so-called activist investors who use social media platforms and online forums to band together and bet against companies and hedge funds.

GameStop became the focus of a trading frenzy at the beginning of this year, surging to a valuation of $34 billion after the co-ordinated actions of amateur investors via online trading discussion groups like r/wallstreetbets, found on Reddit. The collective actions, plotted on online forums, can drive up stocks that hedge funds have bet against, aiming to punish the big players in the stock market.

At the centre of this was Robinhood, the trading app that became the vehicle for amateur investors to take on Wall Street and teach hedge funds a lesson in the GameStop debacle. However, when Robinhood suspended trading on GameStop, retail investors were outraged, claiming the move had protected the hedge funds and institutional investors.

While some herald activism as democratising finance, others warn that online threads are leading young and inexperienced investors to make wild and risky bets, and put vast amounts of personal capital at risk.

While activist investing is nothing new, the GameStop incident is very different to normal behaviour.

“This is normally about buying shares in underperforming companies and then using shareholder influence to effect change such as removing the board or management, altering the strategy or restructuring the business to improve profitability and shareholder returns,” says Jason Hollands, managing director of Bestinvest, the online investment service.

“This new phenomenon of private shareholders piling into a stock like GameStop is very different. The objective is primarily to give a black eye to other investors by mispricing the shares. This upends the whole purpose of investing, which should be to allocate capital with companies that will make good use of it and return profits.”

A resurgence of equity investments

With people having more free time to trade in stocks, alternative forms of entertainment closed and government cash handouts widely available, companies such as Robinhood have seen a substantial increase in users, says Maxim Manturov, head of investment research at Freedom Finance Europe.

In America, equities have always been seen as the place to invest and now people who are out of work are looking for alternative ways to create cash

“In the United States, people are coming back to equity markets to boost incomes that have been reduced through the response to the pandemic,” says Stuart Lane, chief executive of Trade Nation. 

“This is being encouraged by the record highs being hit on the major indices, plus fear of missing out. Also, for many people, trading is an expression of individualism and an opportunity to take risks at a time when many feel their freedoms are being curtailed in other ways.”

Anna-Sophie Hartvigsen, co-founder and partner of Female Invest, says that while activist investors may cause large fluctuations in individual stocks, they are unlikely to impact the overall market. The best way to guard against single-stock fluctuations is to diversify risk and invest across different stocks and asset classes.

“In many ways, the risk of activist investors is no different than any other type of risk and therefore the solution is the same,” she says.

The frenzy over app-trading risks luring inexperienced investors into overpriced and underachieving companies, says Hollands. It gives the impression that “playing the stock market” is a get-rich-quick game built on short-term share price movements.

“In reality, true investing is about buying great companies for the long term and not short-term speculating,” he says. 

The risks of joining the online ‘hype train’

Regulation has not yet stepped in because it will always lag behind innovation, say Fiorenzo Manganiello and Nessim-Sariel Gaon, co-founders of the LIAN Group.

“Platforms like Reddit’s wallstreetbets provided the possibility of rapidly sharing material information and an environment where the ‘little guys’ can join forces against the institutional investors, squeezing out their short positions on companies like GME, AMC and BlackBerry,” according to Manganiello and Gaon.

“While this has all been great fun for some of the market participants, there is considerable risk and losses borne by the investors who joined the ‘hype train’ late and endured considerable losses in the process. Many of them could trade with leverage, getting exposed to additional risk.”

Indeed, “meme stock” stories, like the GameStop saga, merely act as examples of how easily inexperienced investors can be pulled into making potentially damaging financial decisions, says Edgar de Picciotto, co-founder at ikigai, a premium banking and wealth management fintech.

Soaring price momentum in stocks, where the only appeal is a vocal community of investors buying into them, is hugely risky

Ben Hobson, markets editor at Stockopedia, says hedge funds and deep-pocketed investors have always taken big stakes in troubled companies so they can influence board-level decisions.

He says the risk isn’t so much about activism but more to do with the age-old stock market problem of investors herding together to create bubble-like conditions. 

“Soaring price momentum in stocks, where the only appeal is a vocal community of investors buying into them, is hugely risky. Without a good quality business or attractive valuation, things can get very volatile very quickly,” says Hobson. 

Seth Ward, co-founder and chief executive at Pynk, says investors, particularly large ones, have never before had to answer for their actions.

“It’s almost impossible to hide what you do today. And the consequences of business decisions have never been more apparent,” he says.

His advice is to keep applying standard, best practice, long-term investment strategies, for example diversification will give you good protection against one or two shares moving out of sync with the fundamentals for a period of time. 

Also, keeping an eye on investment subreddits might help you in more ways than one; it’s an important part of the market and might give you some fresh perspective, which is rarely a bad idea. “Don’t over leverage, don’t invest more than you can afford to lose,” says Ward.

New opportunities for active management

Social media chat rooms are beginning to resemble the squawk boxes on fast-paced trading floors, says Michael Kamerman, chief executive of online trading venue Skilling. 

“What started out as a combination of vast numbers of remote workers looking to take up trading with more time on their hands, coupled with greater volatility in financial markets and the rise of digital brokerages, has evolved into a retail trader mindset revolution,” he says. 

Yet, if anything, prices moving to extremes in both directions creates a more fertile environment for fundamental active management, says Kasim Zafar, chief investment strategist at EQ Investors. 

“The biggest lesson from this sort of thing is that investing is a serious business. It requires skill, care and due diligence. If any of these are lacking, one runs the risk of being a ‘punter’ rather than an investor,” he says. 

Samuel Leach, chief executive of Samuel & Co Trading, says markets are efficient and, if people find a way to ‘beat the system’, this tends to only last for a short time before the market adapts and removes such arbitrage opportunity. 

“This puts more risk on the retail investors who are putting their life savings into these stocks in the hope that the rally will continue,” he says. “With investing, it is a zero-sum game, therefore for you to win, someone else must lose.”