Hedge Funds, Gamestop and Short-Selling Explained

I imagine you’ve heard a lot in the news about Gamestop stock. You’ve probably heard things about hedge funds and shorting stocks and other incomprehensible chatter.

 

Let’s take a look.

 

This is actually a great time to talk about hedge funds as a whole, and then we will get into the nitty-gritty of this current situation.

 

A hedge fund is an investment managed by fancy people that uses non-traditional ways to make money. Normally you need to be quite wealthy to buy into the fund.

 

Here are some of their strategies:

 

Many hedge fund managers use leverage to boost returns. This means that they borrow money and then use the proceeds of that loan to invest. While they need to pay interest on the money they borrowed, their strategy is to make more money on their investments than the interest rate from the loan.

 

This can dramatically increase risk. It’s kind of like getting a $300,000 loan on a house and its value goes down to $150,000. If the bank wants the money from the loan back, you are in a big pickle.

 

Many hedge fund buy companies that are facing bankruptcy, hoping they recover, which makes could make the hedge fund a profit.

 

Shorting stocks. This is what got hedge funds in trouble with Gamestop. Shorting stocks means that the managers are betting that the stock price is going to go down. This is a silly bet considering the stock market goes up almost all of the time.

 

They invest in non-traditional asset classes such as currencies and commodities.

 

Often, times they utilize quantitative strategies using computer models to identify investment opportunities. They can utilize an unlimited number of variables, which are programmed into complex, frequently-updated algorithms. (sounds fancy- means nothing)

 

It’s not fair that only the rich have access to such investments! Why can’t the common man make money like the rich? Right?

 

I have a dirty little secret. In my opinion, hedge funds are a completely bogus investment that pull money from the wealthy because they like the exclusivity of the investment opportunity.

 

All of those strategies I just mentioned above? None of them are proven to work. None of them. They might sound enticing, but that doesn’t mean they are a good idea.

 

Now don’t get me wrong. I don’t think hedge fund managers are intentionally ripping people off. They really believe that they can make more money for their clients than the use of traditional investing strategies.

 

The fees on hedge funds are high. They use a “2 and 20” model. That means they get 2% of the portfolio value as well as 20% of the gains. If you invested $100,000 into a hedge fund and the fund made $10,000, you would receive around $6,000. Great deal right? (I’m being sarcastic.)

 

This brings me to Warren Buffett and a bet he made ten years ago. His bet was this: He bet $1,000,000 that the S&P 500 would make more money than hedge fund managers.

 

The hedge funds would blow Warren Buffett’s boring strategy out of the water, right? The hedge funds had every strategy at their disposal. Investing in the 500 biggest companies in the U.S. is so boring.

 

The final score over ten years:

 

The S&P 500 made       125.8%

The hedge funds made  36%

 

This is why I absolutely love the current David vs. Goliath battle on Wall Street. A bunch of younger investors are intentionally buying up shares of companies that will hurt hedge funds badly.

 

Gamestop is a struggling retail video game chain. Some feel like it could be bankrupt in the coming years. Several hedge funds made a huge bet that the stock would go down. They did something called “shorting the stock.”

 

I’m not going to go into the technical details. You can just look up a video on Youtube.

 

But if you short a stock that is valued at $100, if it goes down to $80 you make $20. It is the opposite of conventional investing.

 

But what if the investment goes up? This is where it gets complicated.  Let’s look at the Gamestop example.

 

A bunch of millennials online figured out that one particular hedge fund made a huge bet that Gamestop would go down in value. This group said, “Let’s stick it to these fat-cat Wall Street guys.  We know that if the stock price goes up they are in a very tough position.”

 

At the end of the day, Gamestop went up by 1700%. These hedge fund managers were hemorrhaging money. The hedge fund managers started to panic and the trades they made drove the price up even more. The price kept going up because the hedge fund guys had to fulfill their short sale. It got out of control. One hedge fund lost 50% overnight. There were a couple of hedge funds that would have gone to zero, but a couple of other funds bailed them out with loans.

 

So were the hedge fund managers hurt by all of this? No. Their clients were devastated. The fund managers already made hundreds of millions of dollars for themselves. And their clients? Oh well. They knew the risks when they bought in. (I’m being sarcastic again.)

 

All of this to say:. I grit my teeth anytime I hear the word “hedge fund.” They trick the wealthy into paying Wall Street guys crazy amounts of money for an investment product that stinks.

 

Be Blessed,

 

Dave

 

 

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