Hedge Funds Always Win

Over the last week, financial media has exhaustively covered GameStop’s wild ride from roughly $77 on January 25th to $70 — where it trades as I type — roundtripping a move as high $483 per share in between. As we all know, a social media fueled trading frenzy sent the share price surging in the most extreme short squeeze I have personally ever witnessed. But all that juice looks to have been squeezed by now.

Over the past few days, I have been captivated by this violent market whipsaw, with shares moving 100 percent to 200 percent day in and day out. Many have portrayed this story as a band of merry men going after the big bad hedge funds of Sherwood Forest. It’s a classic David versus Goliath story, and everyone loves rooting for the underdog, particularly when it’s against the fat cats of Wall Street. 

With more shares short in GameStop than were outstanding, hedge funds simply got too big in the stock, and they got caught. After all, hedge fund stock operators have colluded to manipulate stock prices and short companies into the ground forever, right? This time the retail investors banded together and pushed the stock higher, forcing the hedge funds to buy back shares and cover their shorts, which pushed price even higher in so doing. It’s about time the little guys got to join in the fun and give Wall Street a taste of its own medicine.

That makes great copy, but like always, the truth is a bit more nuanced than that. 

With more than 20,000 comments on the WallStreetBets Reddit page for GameStop stock, individual day traders have been hyping the stock for some time, clearly aware that several hedge funds had large positions in the stock. Indeed, many of the comments specifically targeted Melvin Capital by name, who suffered substantial losses on their shorts. And although I suspect regulators will find it difficult to successfully prosecute any of the individuals posting on message board for market manipulation, with comments like “PUSH GME TO THE MOON” and “Allll you hedge fund f**kers, f**k you too,” some message board posters are asking for trouble. 

One particular trader — Keith Gill, who goes by the name "DeepF***ingValue" on Reddit — was a vocal proponent of the stock, posting about it as far back as June 2019. He was a driving force on the subreddit and posted pictures of his account balances over time. Gill, who recently left his position as a financial advisor with a large firm, could find he faces some regulatory issues due to his behavior over the last few weeks, in part because he is also a CFA charter holder, and he may not have notified his previously employer of his personal trading activity. 

Unlike many of the commenters on Reddit who were clearly adding to their positions when GME had already been pushed up into the hundreds of dollars, it appears Gill didn’t quite round trip it — he first bought the stock at $5 — but on Tuesday Gill posted a picture of his account value, showing he lost $13 million just that day. 

All told, it looks Gill may have made as much $48 million in paper gains at the peak, and then lost more than half of that, all within the span of a week. Given the trajectory of the stock since, I hope he has already sold the rest of his position for his sake, and for the sake of the hundreds of followers on the subreddit, who promised, “IF HE’S STILL IN, I’M STILL IN.”

And I’ll bet at the end of the day, more individual investors will have lost money on this trade — buying into the hype on the way up, only to watch it crash back down below their entry point before they could exit — than will have actually locked in realized gains. And in an ironic twist, most of the biggest winners appear to have been hedge funds themselves who profited in the massive run-up in price. 

The distressed and event-driven hedge fund Mudrick Capital — with around $2.7 billion in assets, according to its most recently filed Form ADV — reportedly made $200 million on a combination of several Reddit-driven stocks, giving the firm a 9.8 percent gain in January. And Senvest Management, a contrarian, deep-value hedge fund with roughly $2 billion in AUM, did even better, reportedly booking $700 in profits on Game Stop alone. 

It’s really hard for investors to time the markets, and even harder when you are going up against deep-pocketed, well resourced, full-time professionals with teams of people competing against you. It’s part of the reason why active traders do far worse on average than simple buy-and-hold investors. 

Research from behavioral finance gurus Terrence Odean and Brad Barber looked at the trading behavior of 65,000 households on a large brokerage platform and investigated the impact of message boards on returns. What they found was that those investors who most aggressively bought and sold the highest attention-grabbing stocks — like Game Stop this last week — did far worse than the more plodding buy-and-hold types that didn’t trade much. In fact, the 20 percent most active traders in their research under-performed the least active fifth of investors by 5.5 percent per year — massive negative behavioral alpha. 

Markets are like the ocean. Neither good nor bad, they just immutably, inexorably are. Instead of trying to force your will upon them, investors – like swimmers – are better served by simply trying to learn their cadence. Once you understand what you are – and more importantly aren’t – capable of in the face of such irresistible force, one can learn to simply ride the waves instead of exhausting yourself by trying to fight them, only to find you’ve actually made no progress at all. 

And that’s why I’m probably not even going to check the value of my equity accounts. I’ll just put the same amount from my next paycheck into my index fund like I always do, and I’ll continue to let the waves move me forward.