USA Today’s personal finance and markets reporter Jessica Menton breaks down how hedge fund day traders are being wrecked by Reddit users. USA TODAY
In the middle of a pandemic and slow economic recovery, Americans think they’ve identified their Wall Street villain: hedge funds.
Their nemesis is summed up in a few searing images: a hedge fund manager who makes millions betting that the subprime mortgage market will collapse, without warning them. Or another relaxing on a yacht as the economy tanks.
Years of anger culminated late last month when a group of angry small-time investors on Reddit took on a few of those firms in the GameStop “short squeeze” frenzy. That spurred millions of others to join in, as their effort to drive up the price of a stock perceived as undervalued soon shifted to a campaign to “Stick it to Wall Street.” They used the “squeeze” to rally the share price and make profits for themselves while forcing the hedge funds who had bet it would fall to buy it to prevent greater losses.
So what are these funds and where does this resentment come from?
Hedge funds, known for using higher risk investing strategies, are private investment vehicles that typically wealthy individuals use to get higher returns. They control more than $3 trillion in assets globally. But they’ve angered many Americans by gutting companies like former American retail icon Sears, causing layoffs and engaging in questionable financial practices that contributed to the near collapse of the U.S. financial system in 2008, experts say.
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“Most people see it as guys in suits looking down their nose at you,” says Adam Bixler, 28, an active user on the WallStreetBets Reddit forum, whose members led the charge against the funds. “How I feel is probably how a lot of people feel when thinking about the financial crisis and the massive wealth inequality that exists in this country.”
Radio Shack, Toys ‘R’ Us and Payless ShoeSource, along with popular mall-based retailers like the Limited, Wet Seal, Claire’s and Aeropostale faced further financial woes after hedge funds and private equity firms loaded them up with debt.
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“The idea that you can crack open a hedge fund like a piñata and redistribute all this money to people in the form of a short squeeze is very appealing,” adds Bixler, who lives in Boonton, New Jersey and works as a product manager for a company that makes software and tools for the advertising industry. “These are the stimulus checks that everyone wanted.”
Proponents of hedge funds say the firms identify and support distressed industries like retailers and newspapers. These funds are also owned by groups of big investors pooling the savings of millions of unionized workers, like teachers and firefighters, who count on hedge funds to grow and protect their nest eggs.
Even so, hedge funds are viewed as vultures to many Americans.
Kaysha Apodaca, an emergency room nurse in Dallas, Texas, was furious last summer when she lost thousands of dollars after CytoDyn, a biotechnology company that she owns, was hammered following a negative report from a “short selling” research firm, about one of CytroDyn’s drugs in clinical trials. The post with the research was later pulled.
This year, Apodaca thought she missed the opportunity to jump in and buy GameStop or AMC, so she supported the Reddit campaign against hedge funds by investing a few thousand dollars into shares of Nokia, another beaten-down stock that has been discussed on the forum.
“I hate hedge funds. Even if this goes to zero, I’m OK with it. I’m not selling, just to prove a point,” Apodaca said. “Hedge funds have unfairly made money off retail investors for years. Now they’re getting a taste of their own medicine.”
For Iris Findlay, joining the movement was a way for Americans to show their strength in numbers, the Orlando, Florida, resident said.
“I’m definitely not OK that there are so many billionaires hoarding their wealth while people are struggling, especially during the pandemic,” said Findlay, 31, who is disabled and retired from the Air Force.
To be sure, a large portion of hedge-fund assets are owned by institutional investors, like pension funds and endowments. Hedge-fund research has also been critical in exposing an array of accounting-fraud scandals in recent decades, including energy firm Enron.
“Hedge funds do play a very important role in the financial ecosystem, but at the same time they have a PR problem,” said Andrew Lo, a finance professor at MIT Sloan School of Management.
They are an easy target, experts said, because of some of their high-profile managers whose massive wealth offends Americans who struggle to make ends meet.
For instance, Michael Burry, founder of Scion Asset Management, is an investor whose billion-dollar bet against the housing market was chronicled in Michael Lewis’ book “The Big Short.” He personally collected $100 million and made $750 million in profits for his investors then.
These managers “are seen as multibillionaires that really don’t care about the public good and are focused on enriching themselves and their investors,” Lo added. “But I think that’s a caricature, especially given that hedge funds now have become much more institutionalized as pension funds and endowments are investing in these financial vehicles.”
Who do Americans blame?
When asked who was the “most in the wrong” in the trading mania that set off one of the biggest short squeezes in history, nearly half of Americans polled said it was either hedge funds (27%) or online brokerage Robinhood (22%), according to a Harris Poll survey conducted Jan 29-31 that was given to USA TODAY exclusively.
Just 8% said it was the Reddit retail investors on the r/WallStreetBets forum, who angered hedge funds that had bet GameStop’s stock would remain low. The small-time investors used the forum to help drive up the prices for shares like GameStop, theater chain AMC Entertainment and several other companies.
Many respondents were angry that hedge funds were shorting stocks — betting that the share prices would fall — of companies that average people use and love, according to John Gerzema, CEO of The Harris Poll.
“This wasn’t just an attack on a few weak companies,” said Gerzema. “These are companies that are a part of middle-class America and ordinary people’s lives.”
So how did these funds begin and how did they grow into such big villains in the minds of so many?
What are hedge funds?
Hedge funds are financial partnerships between a professional fund manager and investors who pool their money into the fund to earn active returns.
Hedge funds can be traced back to the 1940s when Alfred Winslow Jones, an investor, sociologist and former Fortune magazine writer, created a “hedge” by “shorting” stocks he thought were poised to fall. The “hedge” was meant to reduce risk and protect against market fluctuations. It was unconventional at the time but remains the basic strategy for these funds. Hedge fund strategies today are more diverse and run the gamut of extremely risky to fairly conservative.
There’s another theory about the origin of hedge funds, and this one is connected to a more beloved figure. Some people credit the founding of hedge funds to Benjamin Graham,a mentor to Warren Buffett and the author of “The Intelligent Investor” — the bible of everyone who loves Buffett’s method of investing. Buffett, one of the world’s richest people and a folksy inspiration to small-time investors, has argued that Graham managed a fund with a “hedge” like strategy in the 1920s.
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How did hedge funds evolve?
Hedge funds have gained in popularity over the past two decades after many of them delivered hefty outsize returns in either up or down markets, an attractive selling point for savvy investors. Some of the world’s largest hedge funds include Bridgewater Associates, founded by billionaire Ray Dalio; Renaissance Technologies, founded by billionaire Jim Simons; and Pershing Square, run by Wall Street billionaire Bill Ackman.
They have historically charged much higher fees than mutual funds, which are professionally managed funds that invest in stocks, bonds or money market instruments.
Since hedge fund managers are nearly always paid a performance fee, or percentage of the gains they create, they have a strong incentive to make money for their investors. For the hedge fund managers to earn performance fees, their investors have to make money first.
Hedge funds charge both an expense ratio and a performance fee. The common fee structure is known as two and twenty — a 2% asset management fee and a 20% cut of generated gains.
How did they become villains?
While many Americans lost money during the depths of the financial crisis, some big-time investors did astonishingly well, including those who predicted and profited from the build-up and collapse of the housing and credit bubble in 2007 and 2008.For those Americans who had had their livelihoods upended in the financial crisis, it left a bad taste in their mouths, experts say.
“They’re associated with ruthless financial institutions that are out there to make money and not care where it’s coming from,” says Itay Goldstein, a professor of finance and economics at the University of Pennsylvania’s Wharton School of Business.
A big winner from that time is billionaire investor John Paulson, a hedge fund manager who is famous for netting $20 billion in profits when he bet against subprime mortgages at the peak of the credit bubble in 2007.
In general, short sellers keep stock prices in check by voicing their opinion on where they believe a stock is valued, said Dennis Dick, head of markets structure and a proprietary trader at Bright Trading LLC in Las Vegas.
“I’m concerned with this public image that ‘evil short sellers are betting against America’ and that it’s ‘un-American to short stocks,’” says Dick. “It’s not like every short seller is making bets against America. They’re making calls on whether a stock is overvalued or not.”
The hedge fund industry has faced a rough stretch in recent years and underperformed the broader stock market, but produced their best return in a decade at 11.6% in 2020, according to data provider Hedge Fund Research. Some received a boost from shares of technology firms and companies that focused on goods that people used when stuck at home during the pandemic.
Americans who don’t invest directly in hedge funds still receive a benefit from the returns that hedge funds generate, according to Daniel Smith, a partner at ACA Compliance Group, a compliance advisory firm for financial services.
Of the $4.5 trillion in state and local pension plans, about 6.9% are allocated to hedge funds, according to data published by the Center for Retirement Research at Boston College, the Center for State and Local Government Excellence and the National Association of State Retirement Administrators.
”Hedge funds help secure the retirement of more than 26 million teachers, firefighters, and other public employees by helping pensions navigate all market conditions and meet long-term financial obligations,” said Bryan Corbett, president and CEO at Managed Funds Association, a hedge fund lobby group.
GameStop and questions of power
The rollercoaster involving GameStop, Reddit and Robinhood has prompted Capitol Hill’s harshest criticisms of Wall Street in years.
Several prominent lawmakers on Capitol Hill have warned of such moments, cautioning that companies and hedge funds have too much power.
One of these lawmakers, Sen. Elizabeth Warren, D-Mass., who is well known for her disapproval of Wall Street, called on the Securities and Exchange Commission (SEC) to address the dramatic swings surrounding these companies.
Warren wrote in a letter that it is “long beyond time for the SEC to act” and asked them to investigate the recent rallies in GameStop, AMC Entertainment, and others that “have seen huge shifts in their share price driven by similar internet reading schemes.”
“These wild fluctuations are just the latest indication that many private equity firms, hedge funds, and other investors, big and small, are treating the stock market like a casino, giving little consideration to the companies, communities, workers, and consumers that may be affected by these risky bets,” she wrote.
The House Financial Services Committee will hold a virtual hearing on Feb. 18 regarding “recent market volatility” involving GameStop and the other companies. According to POLITCO, the CEO of Robinhood, Vlad Tenev, is expected to testify.
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Does the movement have legs?
Questions have also been raised as to whether the populist movement threatening to disrupt the financial system will be sustained.
It’s too early to tell, some experts say.
“It has the potential to gather momentum. It depends on whether we see other related episodes in the next few weeks that show the same kind of patterns in the financial markets,” Goldstein said, but added that “We live in a period of so many unusual things going on that it will probably take the edge off this event.”
Hedge funds like Melvin Capital Management, which took the brunt of losses recently from soaring stock prices of GameStop and other heavily shorted stocks. But others made a ton of money on the rally, including Senvest Management with a profit of nearly $700 million, The Wall Street Journal reported.
“Is it sticking it to Wall Street? Only temporarily, but in the long term probably not,” Goldstein said. “At the end of the day, the sophisticated financial institutions will find ways to recuperate and make money out of this.”
Lo of MIT agrees.
“This incident highlights the growing dissatisfaction, distrust and dislocation that many people feel with respect to the financial sector,” Lo said. “It suggests that people are sick and tired of being disenfranchised and being pushed around by large financial institutions.”
Contributing: Savannah Behrmann
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