Tom Bailey: does GameStop herald an active management renaissance?

With social media investors pouring money into so-called meme stocks, will active managers start providing better performance?

The biggest investment story so far this year has been the GameStop (NYSE:GME) mania. The small-cap US video game store saw its share price appreciate by several thousand per cent due to investors, coordinating through the Reddit WallStreet Bets forum, clubbing together to buy the stock and push up its price.

However, this is also part of a wider story of the rise of the social media day trader. Across the world, but particularly in the US, there has been an uptick in members of the public buying and selling shares, often using small amounts of money. Tips about which stocks to buy are shared across social media platforms such as TikTok, Instagram and the aforementioned Reddit. The equities purchased are often called “meme stocks”.

Many have speculated that driving this upswing in day trading is lockdown boredom. Matt Levine, a columnist for Bloomberg News, has termed this the Boredom Market Hypothesis. According to this theory: “Stocks these days are driven not by rational calculations about their expected future cash flows, but by the fact that people are bored at home due to the pandemic and have nothing better to do but trade stocks with their buddies on Reddit.”

Whatever the cause of this increased interest in meme stock day trading, it is interesting to consider what impact this may have on the active versus passive debate.

There are many ways to explain the so-called efficient market hypothesis. My favourite, however, is what we can call the “pool of victims” variant. The theoretical basis of this should probably be attributed to the Nobel Prize-winning economist William Sharpe who wrote a paper called “The Arithmetic of Active Management”, which was published in 1991.

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In this paper, Sharpe essentially argues that active investing is a zero-sum game. He writes: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs.”

What this means is that for one participant in the market to outperform the market, another participant must also underperform. So, for example, if a fund manager is overweight Amazon (NASDAQ:AMZN) (owning a greater percentage than the index) and it causes him or her to outperform the market, someone else in the market must, by definition, have been underweight the stock (holding a smaller percentage than the index) and will therefore have underperformed.

So what does this have to do with GameStop and meme stock traders? Well, if investing is a zero-sum game, as described above, outperforming the market is easier if there are more unsophisticated investors who will wrongly go either under or overweight a specific stock. Put differently, there is a ready pool of victims for professional managers to outcompete. But over the past few decades, that pool of victims has been shrinking, with money increasingly being professionally managed.

From the early 20th century in the US, stocks increasingly became owned by households. According to the research paper “Agency Capitalism” by Ronald J. Gilson and Jeffrey N. Gordon, in the US in 1950 “equities were still held predominantly by households; institutional investors, including pension funds, held only approximately 6.1% of equities”.

However, over the next 30 years, that changed. US household investors increasingly opted for professionally managed investment funds. Meanwhile, the growth of workplace pensions schemes meant increasing amounts of money was being professionally managed. As a result, by 1980 a quarter of US equities were owned by institutional and professional investors. By 2009, that reached over 50%. Today, the figure usually given is somewhere around 80%.

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All those stocks were now owned by professionally trained investors with excellent research capabilities. As a result, the maths of beating the market became much harder. Other professional investors are much less likely to be underweight or overweight the wrong stocks. As a result, many bad active managers or active strategies have had to throw in the towel – however, that has meant that the competition has become even tougher for those who remain.

So, with the new rise of social media-driven trading, is the market’s maths now becoming more favourable for active managers? If the market is seeing an increasing amount of novice investors buying or selling stocks on the back of social media tips, with little or no regards to financial fundamentals, does that increase the “pool of victims” for active managers, making outperformance easier? 

Perhaps. However, a few things to keep in mind. First, the actual amount of money the much talked about Reddit and TikTok investors represent is still tiny. Trillions of dollars globally are still managed by professional investors.

But even if the rise of the Reddit Trader did make markets easier to beat for some active managers, the investor is still stuck with the conundrum of trying to work out who those fund managers will be. It is not as if no active managers outperform – many do! The problem is identifying, ahead of time, which one will do the outperforming.

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Even if the number of outperforming fund managers significantly increases, trying to identify who they are would be no simple task. Then, of course, you would have to make sure that the manager you identified would go on to consistently outperform, or know when to sell.

So, as you might expect, my preferred option is for most (most!) of a portfolio to be in passive funds, even if we end up seeing more fund managers beating their benchmarks.