“Wall Street” is All of Us

A Quick Overview of Hedge Funds

A hedge fund is an investment vehicle that trades in (relatively) liquid assets, using a range of complex investment techniques that help maximize returns. Hedge funds are often referred to as a separate asset class — nestled somewhere between the wholly available public markets and the traditionally unavailable private markets. Since they often trade publicly listed securities, but are only available to the highly accredited, their grey-area status makes some sense. For others, hedge funds are nestled firmly in the private markets and within alternative investment strategies, signalling their relatively inaccessible status across investment products. This positioning might be our first mistake. Hedge funds are more of an investment structure than they are their own asset class. Hedge funds are formed through an investment partnership, often through pooled funds, that have extreme freedom in how they buy, sell, and trade securities (more than your traditional mutual fund.)

  • Investors borrow shares (usually from a broker) for a duration up to 12 months.
  • At the end of the loan period, the investor has to return the stocks.
  • Just as in a traditional loan,the investor has to pay interest to the loaning broker while they use those stocks.
  • The key difference in this type of arrangement vs. a more traditional loan is that the broker can (typically) ask for the shares back at any time, which adds additional risk for the investor.
  • The stock itself is overvalued and will correct itself through the usual machinations of the market.
  • There is new information available in the markets within which the stock operates, that will result in a decrease in share value.
  • There is legal, regulatory or financial action that might devalue the stock.
  • And most commonly, to offset long positions they also own (an equally speculative assumption that bets on the value of a share price increasing.)

So what happened with GameStop?

In essence, something called a short squeeze. A short squeeze occurs when the value of the stock begins to rise, as opposed to the investor’s expectation of the value declining. Short sellers must cover their trades by buying those short positions back — now at higher values. Remember that the investor borrowed those shares - they need to give them back to the original owner. The buying-back creates a feedback loop — demand for the shares increases and attracts more buyers, which pushes the stock price higher. And investors need to do this quickly — the higher the price rises, the larger their overall loss. The increase in the stock price causes even more short sellers to buy their shares back to cover their positions. Welcome to the investment free-for-all.

The actions of the Price Fixers are not much better than the hedge funds that were targeted

Short sellers take on short positions based on their own insight and expertise (and sure, sometimes whims) around how stock prices will behave. The Reddit investors created an arbitrary run on a poorly performing stock. GameStop stock was already struggling and short positions on struggling companies (who are more likely to see their stock values naturally decrease) are common. There was no new material information on GameStop, the market, or any other investment-related consideration that justified such a drastic price increase. That’s very different from how hedge funds make these bets.

Hedge funds manage our money too

The rallying cry of this effort by its perpetrators was to “fight for the little guy” — the typical individual investor who is shut out of a mostly accreditation-driven investment market. The effort to democratize access to the investment universe is an important cause. One deeply worth fighting for. And it is true that individual investors have fewer opportunities to use hedge fund tricks — like speculation. But the idea that a scheme of this nature hurts the hedge funds themselves — instead of us, the people — demonstrates a deep lack of understanding of the cyclicality of markets.

  • Chris James (a hedge fund veteran who started Andor Capital Management in the early 2000s) launched Engine №1 to engage its portfolio companies to invest in “workers, communities, and the environment” and align “the interests of Main Street and Wall Street.”
  • And Two Sigma — a $58bn New York-based hedge fund manager has just launched Two Sigma Impact, “a private investments business focused on combining active, principled ownership and data science with the goal of delivering superior returns and positive social outcomes.”

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Rehana Nathoo

Rehana Nathoo

#impinv founder at Spectrum Impact. Ex @CaseFoundation + @BNYMellon + @RockefellerFdn. Bookworm, travel glutton, and lifelong Pens fan. www.spectrum-impact.com