How hedge funds work
ETFs, mutual funds, and the stock market generally are open to all. In contrast, a hedge fund typically requires much higher capital and caters to accredited investors. Minimum investment amounts, where applicable, are within the reach of most people who can claim steady employment and can often be circumvented by systems like fractional share ownership. All of these are tightly regulated and quite transparent, too. Legal bodies like the SEC do drop the ball from time to time, but the threat of prosecution generally keeps fiduciaries on the straight and narrow.
Hedge funds are completely different animals. Aimed at “sophisticated investors”, essentially meaning those with high personal net worth, they charge high fees and generally won’t even cash an investor’s check for less than $100,000, with some requiring an initial deposit of over a million. They are not required to follow the same investor protection regulations as other funds and, most significantly, are allowed to pursue complex, high-risk strategies in pursuit of profit.
Hedge Fund Idea Dinners for Movers and Shakers
Have you ever heard of an “idea dinner”? It sounds like a blog you would read on BBCFood.com when unsure what to make on a Thursday night. But, in the world of high finance, the purpose of these dinners is quite different.
At these idea dinners, powerful and well-connected investors – hedge fund managers and others who travel in the same circles – meet privately at fancy restaurants, often in New York or London. There may be some socialising involved, but attendees are primarily there to talk about investments. As part of the cost of admission, each person is expected to bring one idea for a trade in stocks, bonds, currencies, or other assets to share with the other diners.
So, okay, “sharing is caring,” and we do much the same thing at my weekly book club. However, things are a little different when these investors control millions, if not billions, of dollars in capital. If they agree on an idea and act on it, each separately but effectively in concert, the sheer amount of money involved can quite easily be enough to move the market in the direction they were hoping for.
Needless to say, the contents of the discussions at these dinners aren’t made public. Nevertheless, word travels fast in the City and on Wall Street. Before long, other in-the-know hedge funds and investors get into the same trade, understanding the buying power that is behind it. Next, when the price begins to move, savvy individual traders get an early seat on the bandwagon and try to ride the trend. Finally, what’s left are those known as the “bag holders” – the out-of-the-loop, mom-n’-pop investors who only get in on the action when it is already well away from the entry price the idea dinner attendees enjoyed.
Who ends up holding the bag
At this point, the hedge funds divest their holdings at a tidy profit, while the rest scramble to get out as the trend stalls and the price rolls over. The last to get in, in this example meaning those furthest from the locus where decisions affecting the stock market are taken, are left holding the bag of losses.
It is quite easy to make the case that the above scenario is not fair to all investors. However, life itself is not fair, and the view of many successful investors is that these latecomers, perhaps motivated by greed rather than any real understanding of how the system works, deserve whatever they’re handed.
Whichever way you slice it, the waves of buying and selling pictured in the graph above provide bountiful opportunities for profit as long as you time them correctly. Instead of whining about the lack of equal opportunity for all, the smart and prudent and the stupid and reckless alike, we’d be better served thinking about how we retail investors can level the playing field.
Technology and knowledge are power
The internet, as in so many areas of life, continues to empower individuals that were once unable to participate meaningfully in the mainstream of life. This is most certainly the case when it comes to small-scale investing.
Once upon a time, starting to invest in anything but your employer’s pension fund required making an appointment with a stockbroker; you were expected to wear a jacket and tie. Today, online trading platforms have made low-cost, low-minimum transactions the standard for retail investors. The most onerous part of the process is proving you are who you say you are. By some estimates, small, independent investors now account for as much as a quarter by volume of all equity trading in the United States.
More significantly, the internet has given ordinary people the same access to information as organised capital and institutions enjoy. You can now google something that might have once only been available through a select library or, perhaps, by knowing the right person. The timeliness of information is no less revolutionary: instead of looking up a stock’s last closing price in the newspaper, you can see it fluctuate in real time on your phone.
Making sense of it all
Alas, data, however plentiful, is not the same thing as insight. Fortunately, a number of online forums have come to fill this need, giving whoever’s interested the opportunity to share information and ideas instead of operating in a vacuum.
Of course, one of the results of everyone being able to voice an opinion is that some of the opinions are produced by crackpots. The upvoting system used to rank posts in Reddit does a good job at filtering out the chaff and bringing the best ideas to the forefront. We’ll leave it to you to find the subreddits best suited to your needs. Outside Reddit and the wilderness LinkedIn has become, other discussion forums worth checking out include:
Meme Stocks: When Retail Investors Beat Hedge Funds
Some of the information found on these discussion boards are best ignored, including anything related to “hot tips” or “guaranteed strategies”, or any commentator who doesn’t explain their reasoning in detail. At the end of the day, every retail investor is responsible for their own decisions, and these should ultimately be based on publicly available information about the stock.
Another kind of suggestion to be wary of is those that relate to “meme stocks”: those that have experienced a viral surge of interest on social media, without some change in the company’s fundamentals to justify any surge in price. However, the hype does sometimes have a basis in fact, as with the GameStop short squeeze of early 2021. When enough retail investors find reason to believe in the same trade and collectively commit the buying power to pull it off, even powerful hedge funds can find themselves on the wrong end of tactics they themselves routinely employ.
Not every Reddit user is an investing genius, of course, but many of them do produce lots of good fundamental research and technical analysis. With some care, the insights you garner there can easily match the ideas proposed be professional researchers. Equally, there are some really silly ideas to be found, defying any logic – caveat emptor! Realistically, though, the same thing can be said about mainstream analysts, who often follow a prevailing narrative that sometimes turns out to be quite wrong.
Do professional investors really beat the market?
There certainly are genius professional investors out there. We all know the names Warren Buffett, Ray Dalio and, more recently, Kathy Wood. But it is quite easy to make the case that most professional investors are not oracles. Just look at the data representing how many active managers outperformed their benchmark in recent years:
On top of that, many of the investment managers that are outperforming their benchmark are piggybacking on other hedge fund managers’ ideas, or simply riding the momentum of the market. For example, the FAANG group of tech stocks have done well for years. Simply buying into an already working idea has made many professional investors (as well as retail investors) very wealthy, but it is no proof of market acumen.
Hedge Funds vs the Crowd: Final Thoughts
To an outsider, it often seems like the investment world is a kind of old boy’s club run for the exclusive benefit of its members. There is some support for this hypothesis, like when a well-respected financial publication recently referred to massive insider trading as “enabling those involved to make more informed investment decisions”.
However, the democratisation of information and much lower barriers to entry mean that you don’t need to be invited to a Wall Street idea dinner in order to make a profit in the markets. Newly empowered investors who’ve learned the industry jargon and a little about technical analysis can, with luck and skill, perform just as well as hedge fund managers.
Small investors don’t have access to the same asset classes, too, but there are alternatives open to them, including investing in small businesses and making peer-to-peer loans. In fact, it may not be long until a new kind of investment vehicle, similar to a hedge fund but using a kind of crowdfunding model, emerges.
