Why “You” Have the Upper Hand Against a Hedge Fund Manager

One of the questions that I am most asked is “Why does a regular retail investor, like mom and pop, who trade a few hundred shares at most at once, have the upper hand against a hedge fund manager who can call up CEO’s and manage billions of dollars?” I will explain that here.

If you manage your retirement pension of a few hundred thousand dollars, chances are most hedge fund managers made more than you. Actually, they all made more than you. However, it does not mean that you are in a worse place in terms of getting returns on the investment. In fact, hedge fund managers would kill to be able to trade like you, but with billions of dollars. This is the case for 5 reasons:

  1. The dilemma of dealing with incoming cash;
  2. The buying & selling pressure from the market and the clients;
  3. Fewer investment selections;
  4. Artificial rules as obstacles;
  5. Getting front run.

 

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The dilemma of dealing with incoming cash

For a manager, getting investment is a good thing. It is a sign of recognition and it also means they are about to get paid. In fact that is something that only the relatively successful managers do. It is not hard to understand that if a manager lost all of the money under management on silly investments, not many people will choose to invest in the fund anymore. However, after a manager becomes successful on what have turned out to be profitable investments, the money that comes in makes it very difficult for them to continue the success, and sometimes even directly causes failures.

In order to illustrate this, let me provide an example. Suppose our fund manager David here is very smart and he manages about 5 million dollars to buy stocks. The fund returned very positively in the past few years. The reason David is doing well, is not that he was lucky and used the clients’ money on a roulette table and won, but that he is not only smart but also hard working. David researched and picked out 10 stocks that he believed would out-perform the market; and they did. For the sake of simplicity, let’s assume he bought all 10 stocks at a price of 20$ per share; and now they have all gone up to 30$. His success got around and many rich people now are looking to invest in David’s fund. As a result, he received another 5 million dollars. David gladly took the money and put it evenly across the 10 stocks he already owned. Prior to the extra investment, the stocks that David owns would have to dip 33% for David to break even. However, since David purchased another 5 million worth of shares at a price of 30$ per share, his average price for all the shares is now at 25$. The shares only need to dip 17% for David to lose all the profit he made over the years. Despite the increased risks, David’s research held up. The shares continue to climb the charts. Now, the share prices are all at 45$. David’s name is now on newspaper and TV, known as the next prodigy. A few Silicon Valley power players called him and invested in total of 30 million dollars. David took the money and did what he has done before: putting the money in the stocks he already owned. Now the average price has been dragged up to 40$. The market then experienced a mild correction, and David’s shares had a bigger-than-average tumble of 12% (which is very likely since they had more than average gains). All is lost, and David’s portfolio is now in the red.

As you can clearly see, David’s strategy is not sustainable. As his success grows, he has to always deal with more investment, which continuously drags up his average price along the way. Any mild corrections or decrease in share prices would now instantly wipe out the profit. This is not to mention that eventually David might overpay for shares since the prices have gone up.

Now, you might comment: “That is a stupid strategy obviously, why doesn’t he put the money in other stocks?” The answer is that those stocks are not good enough. If they were, why did David choose the 10 that he chose, instead of other ones? If he receives money once every few years, investing in different stocks might be a reasonable strategy since the companies are now somewhat different. What was good then might not be as good now. However, if a manager gets incoming investments twice a year, they might not have available and attractive alternatives to invest as nothing really changed.

The external buying & selling pressure

Let’s continue our previous example. David is losing money for the first time. The market panics. His clients are angry. They are calling him to withdraw the investments. The newspaper is saying David has “lost his touch.” (They have done so with Warren Buffett during the tech bubble since Buffett was not investing in tech. Point is, the media changes stance like a model changes clothes) David, being educated about the market, explains to them that the loss is temporary and the reasonable thing is to hold and wait until it passes. The clients are terrified of further losses and they are kicking themselves for letting David handle their money. It even annoys them to hear David’s voice. They insist taking the money back. As a result, David liquidates and distributes the money. In two months, guess what happened, the market is up again; but David’s fund is now closed down. Of course this is an extreme example, but the reality isn’t far off. The number one thing fund managers complain is their clients’ impatience. Clients, reasonably being less educated about financial market, want to sell at “times of fear” (which is why it is called “times of fear”). If they do that, they sell it at a loss with no chance of recovering. Therefore, this selling pressure, combined with the inflow of investment you see above, have perfectly created a machine that has the tendency to do the opposite of what is supposed to do: it is selling low and buying high. It is prepared to lose money.

Fewer investment selections

Once the investment fund gets to a certain size, it limits itself to fewer investment options. For one, like the example we discussed above, managers cannot keep investing in the stocks they already owned, because the action drags up the average price and causes higher risks. Another reason for decreasing selections is that as a fund gets larger and larger in size, it can no longer invest in small caps, even if the manager believes that the return will be phenomenal. For example, a 20 billion dollar hedge fund cannot realistically invest in a 500 million dollar small cap. Unless the manager likes to buy out the company, he/she would invest at maximum of 9.9% in order to avoid insider ownership troubles. A 10% investment would for one send the share price of the small cap over the roofwhich would most likely cause the fund to be paying at a significantly higher price at the later end of its acquisition. After all the trouble, this position is 0.025% of its total portfolio. Not Worth it. Buffett often discusses that he cannot realistically consider investments that are below 2 billion dollars for the same reason.

Artificial rules as obstacles

This applies to mutual funds more than it does to hedge funds. Hedge funds are often free as to what they invest. In fact, hedge fund managers can legally go to Vegas and bet on horses if their clients trust them enough. However in the mean time, many mutual funds and pension funds are subject to artificial rules put in place to “stabilize” the return. An example can be a beta requirement. A fund can be subject to a certain beta range. In other words, the beta of all the positions must add up to be within a certain range. This certainly limits the investment options and it strips away a huge degree of freedom on the part of the managers. Another example is indexed stocks. Many other fund managers face with the requirement to buy indexed companies or companies within a certain sector. That again, takes away an incredible number of strategies that the fund managers can impose. If a fund manager is required to only invest in airlines, oil and coal, then regardless of his/her competency and level of work, he/she must have had a terrible year, since those companies get killed across the board.

Getting Front Run

Finally, in the recent years, there emerges a risk of getting front run. I believe David Einhorn talked about that when he placed a trade, the price gets shot up before his order gets filled. In addition, Buffett and Munger also expressed their distain for High Frequency Trading (HFT), and called them “legalized front runners.” The story here is that when a large order gets submitted, the brokers have machines that automatically calculate the potential price effects. They buy the shares first before the order gets filled, and then as the order comes in and drives the price up, they will sell the shares that they just bought a few seconds ago, sometimes to the manager him/herself. The whole action happens within seconds. The truth is, retail investors do not have the power to drive up the price single handedly and hence are mostly ignored by these HFT machines.

 

In conclusion, retail investors have an upper hand in making regular investments in the stock market against the large hedge fund managers, contrary to the popular belief. However, hedge fund managers with billions of dollars surely will not trail behind and they have invented their own advantages in the market. I will discuss that in a separate article.

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