The meteoric rise and subsequent fall of GameStop dominated the recent news. The narrative being individual investors try to take on Hedge Funds. Which got me wondering, what even is a hedge fund?
Please consider donating to my hedge fund, so I can grow this line of Japanese boxwoods.
I don’t think that’s it.
So, I have heard of investment funds before. That’s when my money gets pooled with other people’s money. Quickly walking through a few types:
Money Market Funds
There are money-market funds, which are super-safe, like keeping your money in a savings account. It’s still pooled money that’s invested but in some of the safer investments like Treasury Bills.
Quick aside to answer what is a Treasury Bill. It’s like if the US Treasury (read: government) asked you for a loan just like some deadbeat in-law would. It’s super-safe because, unlike the in-law, the government won’t skip town to avoid paying you back.
That reminds me of an old joke: if you lend your brother-in-law $50 and he never speaks to you again, was it worth the investment? Haha, dysfunctional family humor.
There are also index funds and exchange-traded funds, typically shortened to ETFs, and that’s pooled money that aims to match a particular index. An index is just an established finance benchmark, like the S&P 500 (a collection of 500 US stocks) or the DOW (a group of 100 US stocks). These are typically a means of just trying to match the market.
The pioneer of these types of investments was Jack Bogle, the founder of Vanguard. Way back in the 1970s, he was simplifying investing by creating these funds.
Today there are devout fans of Jack Bogle called Bogleheads. I’ve encountered this group on message boards, and not always in a friendly way. They don’t see eye-to-eye with The Motley Fool, which recommends individual stocks. They are all-in on the philosophy of making index funds your primary investment vehicles (unsure why they call types of investments vehicles, I find that term always takes my mind in other directions).
In truth, they are probably not good investments, but sure look fun to drive.
Probably the most well-known type of fund is a mutual fund. For me, these have been the most frequently recommended by financial advisors and typically what I can invest in within my kid’s college-savings funds or 401K.
Because these funds are not T-bills or following a market index, they need someone to guide them. That’s the fund manager, an investing professional who decides what to invest in and when. Well, sort of when. A vexing issue for the fund manager is when their investing strategy gets railroaded by the actual investors they are serving.
For example, when the market goes down, it’s an excellent time for the fund manager to start putting the fund’s money to use buying stocks cheaper than before. However, if the fund’s investors are freaking out and taking their money out, the fund manager must oblige and may not have money left to buy the cheap stocks. They may even have had to sell to fulfill these obligations, selling, not buying, and at a loss, the exact opposite of what they intended to do.
So what are hedge funds? Pretty much the same thing as mutual funds — pooled money run by a fund manager. The significant differences are that mutual funds are available to the general public like you and me. In contrast, hedge funds are private and very selective, like that club I tried to go to in my 20s in Miami Beach that turned me away for wearing sneakers. In retrospect, they may not actually have been being that selective.
Can I come into your fancy South Beach club?
Hedge funds don’t judge by your shoes but by your net worth. You need to be an accredited investor to buy in, and that means you are worth a cool million dollars (not counting your house) and that you can pull in $200K a year ($300K if talking jointly with a spouse). That’s a high bar for pretty much everyone except the Rich. These funds are for them, and it’s resentment of that point that most likely fueled a bit of the Redditors fury to take them down.
These funds are generally more aggressive than mutual funds and take more risk by employing more investment strategies, so I find it strange they are called hedge funds because hedging is trying to mitigate risk. To understand that, let’s look at the big game coming today, the Super Bowl.
What is hedging?
For this prolonged explanation to work, it’s necessary to know that sports gambling takes many forms. There is the idea of betting on who will win the upcoming game (and when the teams are lopsided, the sportsbooks — the folks managing the bets — will add a spread). Let’s look at the Super Bowl spread.
The Super Bowl spread
I mean the betting spread, which is essentially giving the weaker team a few points from the start. The spread for the Super Bowl is “Chiefs -3”. This means the Chiefs are favored to win. So, for purposes of betting, Tampa Bay is being given 3 points right from the start. To bet on the Chiefs and win the bet, you would need them to win the game by at least 4 points. To bet on Tampa Bay and win, you don’t even need them to win the game; they could win, but they could also lose, as long as it’s by less than 2 points.
That would be betting on the game today. But there are other forms of sports gambling, one of the most common is betting on a team to win the Super Bowl way back at the beginning of the season. How would you know who even will be playing? You don’t. Neither do the sportsbooks. So every team is available to bet on, and there are different odds for each. Everyone knew Kansas City would be good this year. They had the smallest odds of 6–1, meaning you would earn six times your bet if KC wins it all. One of the greatest odds goes to my new hometown team. The Washington (“don’t call us Redskins”, “well what then should we call you?”, “we will get back to you on that, for now just go with the mind-bogglingly uninventive…”) Football Team had odds of 150–1. This means if you paid $100 to bet on Washington, and they won the Super Bowl today, you would win $15,000. Ka-Ching!
Except Washington isn’t playing. So you lost $100. Womp-womp.
But Tampa Bay is. Their odds were 12–1. So let’s say you love yourself some Tom Brady and heard he was now on Tampa Bay. Gronk is there too? He was such a fun White Tiger. So you put down $100 before the season began on Tampa Bay. Now four months later, you are one Big Game win away from turning that $100 bet into $1,200. Go you! That’s great! But if they lose, you will make nothing. Unless… you hedge your bets.
My children will be rooting for Tampa Bay cause they have a Masked Singer alumni on their team.
So, you already will make $1,200 if Tampa wins. How about then if you put a bet on Kansas City to win? If you put a $600 bet on KC, if they win, you win $600; if they lose, you lose that money, but you won $1,200 on Tampa Bay, so minus the $600 lost on KC, you still total $600. You hedged your bet, and now you are sure to win either way (unless KC doesn’t cover the spread and wins by two or less, but hey, that’s why it’s called gambling).
So that’s hedging. And how to Hedge Funds hedge. Well… they don’t, necessarily. It seems like once upon a time, hedge funds took cautionary approaches like settling for the $600 win, but today they are generally more aggressive (betting instead on Tampa Bay again, to win $1800).
Sounds risky; how do they know their aggressive bet will win? In investing, unlike football, there’s a bit of room to will it to happen, like taking a short position in GameStop and then going on financial news shows to talk about why GameStop is a terrible stock.
Cause in investing, there’s no Big Game with a flashy Halftime show to make it simple to follow who wins and loses money. No, for most of us, the markets are more like the Puppy Bowl. It’s not at all clear what’s happening or even what the rules are.
Who’s winning, who’s losing, who cares? They are so cute!
Anyway, I hope that helps get a little better sense of types of funds and what hedging is at least supposed to mean. Enjoy the Super Bowl!
Disclaimers: These opinions are my own and do not represent my employer, The Motley Fool, who doesn’t pay me (or I’m pretty sure anyone) to write about football. I do not own any stocks mentioned in this piece. I have no bets on the Super Bowl. I do think Gronk, while not a good singer, made a great as the White Tiger. While that was just a picture from Google, I hope someday to make a Super Bowl spread that amazing.