The Bear’s Lair: Back the bros against the hedgies

WSB and Dogecoin

“Bros” connecting through the social media forum “WallStreetBets” last week staged a massive rally in the shares of GameStop (NYSE:GME) causing huge losses to a hedge fund that had shorted the stock. Most commentary suggested this should be a rare occurrence, as the hedge fund was a professional investor performing a valuable market function, while the Bros were amateur retail investors. However, in today’s markets, I would bet on amateur investor Bros showing better investment performance than the hedge funds.

The investment management industry is keen to highlight the fairly dubious statistics that show that retail investors underperform “professional” investors over the long-term (and that both underperform the market, a statistic that I have never entirely understood). There are three reasons why for many retail investors this would be the case. First, there are many crooks about in the investment business who prey on retail investors, particularly older and richer ones – this in itself produces underperformance. Second, retail investors who use a financial advisor, as many do, are not getting the cream of the crop (unless they are themselves extremely rich, with a Private Office). Most advisors in the retail investment business would rather be advising institutions, because that’s where the money is, and you don’t have to sell so hard; hence with admirable exceptions the average retail advisor is an underperformer.

Third, and most difficult to get round (and this one applies to the Bros also, who don’t have advisors) most retail investors put new money into the market when it is bullish and exciting, and withdraw money from the market at the bottom, because they get depressed. Needless to say, this is fatal to investment returns.

So how can I claim that the Bros will generally outperform hedge funds?

You have to look at the economic cause of hedge funds’ proliferation, and at the incentive structure within them. Bros, by and large, are risking their own money. They have no mechanism to fund-raise, and hence are focused solely on maximizing investment return. Their one weakness is a tendency towards “irrational enthusiasm” in bull markets, taking larger risks when the market is more overvalued and pulling back when it is low, especially in a period of prolonged undervaluation like the late 1970s.

As for their analytical capabilities, this is not a difficulty these days. There are currently over 167,000 holders of the “Chartered Financial Analyst” qualification, whose ability to analyze financial and market situations is equivalent to that of all but a very few employees of hedge funds. There are also MBA graduates and professional mathematicians lacking the CFA qualification who can do an equivalent job. If they are of the Millennial generation, the CFAs, MBAs and mathematicians will also be at least as tech-savvy as the “professionals.” The days when retail investors were all “little old ladies” to be fleeced are long gone.

There is an overall macroeconomic problem with hedge funds. At least in principle, they are set up to exploit short-term pricing anomalies in stock, bond and other markets, using leverage to turn modest profits into exciting ones. This is an economically valuable activity, and funds to do this have existed since at least the 1960s, although in normal markets there is a periodic weeding out of those that take excessive risk.

However, in the years since 1995 when interest rates have been held artificially low and liquidity artificially high by a Gosplan-like Federal Reserve, hedge funds have proliferated. At first, they achieved high returns; the cost of their leverage was held down artificially, so that transactions that would have been inadequately profitable with a normal cost of leverage became extravagantly profitable. However, as time went on those high returns were arbitraged away by the entry of new hedge funds, attracted both by the initially superior returns and by the ease of raising capital from dozy pension funds and college endowments (we’re looking at YOU, Harvard!) Thus, in today’s market there is far too much money chasing a limited volume of profitable opportunities in the hedge fund space. As a result, hedge fund returns have generally crashed, far below those of the market as a whole.

There are however other reasons why hedge funds can be expected to have poor returns. One is the pervasive office politics in the organizations, full of aggressive ambitious people with few scruples standing in the way of their personal success. If it is socially fashionable to believe in left-wing “cancel culture” and extreme environmentalism, particularly on the climate change issue, that is what the young hedge funders will believe in. Too much money from the hedge funds will then surge into investments that tick those boxes; the price of those investments will be driven up and their potential returns down, even if the environmentally desirable investments are intrinsically economically viable, which most are not.

Another severe problem for hedge funds is their dependence on outside money and their need to file quarterly returns. Bros do not have this problem; they can therefore just “HODL” for years if necessary, waiting for an investment to come right. The spectacular success, albeit on a small scale of Bro investments in the cryptocurrency Dogecoin is an example of this. Founded in 2013, with a picture of Woofles as its symbol, it was intended as a joke, and subjected to the most intense Keynesian money-printing, so that 128 billion DOGE are now outstanding. For years it languished, even through the crypto-currency bonanza of 2017. However, in the last six months, it has soared to around 150 times its initial issue value and a market capitalization of some $6 billion (while still sporting Woofles – a brand is a brand).

Those Bros who have held DOGE right through have enjoyed a true bonanza; even the Bros who bought in six months ago have made 10 times their money. Hedge funds, subject to quarterly reports of investment returns and meetings with their unimaginative investors, would have sold years ago. The liquidity and price transparency of DOGE and other cryptos is in this respect a disadvantage for hedgies; a private equity fund could have ignored the market price and pulled the wool over its investors’ eyes, making deep meaningful statements every quarter about DOGE’s hidden technological potential and the Blockchain.

The other difficulty for hedge funds is that of trusting their colleagues. Bros don’t have this problem; they are lone operators, and how hard they try to stay out of jail is therefore up to them alone. They never need to lie awake at night worrying about the integrity of their colleagues, because they don’t have any colleagues.

Fifty years ago, this was also true in the better financial institutions, where integrity was unquestionable and unquestioned. But in the 1990s, with the advent of massive “compliance” requirements, things changed. A good friend of mine was struggling gamely with the difficulties of compliance for one of the more sporting brokerages of the late 1990s – think a mini-“Stratton Oakmont” the dodgy Long Island brokerage in the movie “Wolf of Wall Street.” When told by a snooty gentleman at a party that he did a similar job for Morgan Stanley, she responded: “Listen, buster! Anybody can do compliance for Morgan Stanley because they never do anything bad. But to keep my bosses out of jail, you need REAL compliance ability.”

Hedge funds are today definitely in the latter category; the days of the old Morgan Stanley are long gone. Thus, their partners must worry all the time about whether one of their colleagues is shading things a bit too much. They must also deal with myriads of compliance officers tripping up over each other, trying to ensure that they don’t. Sometimes it goes wrong; one need only think of the German payments processor Wirecard – payments processing, what could be simpler? — where 2 billion euro appears to have gone walkies, sending the company bankrupt, with only some of the senior management having any idea what was going on. Again, this kind of worry is not conducive to good investment performance – or to a good night’s sleep, the lack of which is also not conducive to good investment performance.

Over the next couple of years, the market is likely to implode because of poor U.S. economic performance. Hedge funds, who are far less hedged than their name would suggest, will equally be subject to a savage weeding out. The Bros will doubtless also suffer, although most of them will find ways to survive and even prosper. When the dust clears from the collapse, there will be few hedge funds remaining, and they will find it difficult to raise new money from the palsied pension funds and the weakened endowments. That is not much loss. Hedge funds are peripheral; we need only a few of them.

Bros, on the other hand are essential to a well-functioning market!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)