As 2020 drew to a close, investors collectively breathed a sigh of relief after one of the more volatile years in recent memory. Then, as if to say, “I took that personally,” 2021 began with one of the most bizarre events in stock market history. A group of investors, led by an online community known as “wallstreetbets,” bought up shares of GameStop, a struggling video game retailer. The stock began the year at $17 and skyrocketed to $348 by the end of January. These actions were broadly interpreted as an attack against hedge funds. But what really happened to hedge funds, and what can we learn about them from this experience?
This blog post explores three lessons about hedge funds in the aftermath of the GameStop saga.
The first lesson is to understand the interaction between fundamental and technical strategies:
Using GameStop as an example, a fundamental analyst might evaluate the company based on its business prospects compared to its stock price and find it to be overvalued (i.e. a poor investment). That analyst may choose to “short” (borrow shares to sell the stock, hoping to profit if the stock goes down in price) the stock. A technical analyst might look at GameStop’s stock price pattern and determine that it is a positive indicator in the short run regardless of its business performance.
These two contrasting styles came clearly into focus during GameStop’s breathtaking run. Many fundamental investors who had shorted the stock in the past refused to be involved in shorting it, even after it had risen more than 10-fold due to the short-term technical backdrop. Even managers without a position — long or short — in GameStop and related names found themselves hurt as hedge funds generally covered their short positions and sold out of their longs due to the large fluctuations in stock prices. For technical investors looking to profit from the short-term spike in GameStop, they had to time their trade perfectly, as the stock quickly dropped back down to $50 in February.
At Canterbury, we typically favor fundamental strategies, as they are based on tangible factors that tend to be more sustainable. It is important to understand that fundamental strategies may be affected by technical concerns in the short run but, in the long run, their performance will be driven by whether the managers are right in their business analyses.
Next, here are some ways that hedge funds may be affected going forward, based on numerous conversations we have had with fund managers:
Despite the bad rap that hedge funds have been getting in the press, these recent events highlight their importance in at least two key ways:
The purpose of this post is not to advocate for or against hedge funds, nor to provide an opinion on GameStop's fundamental business or fair stock price value. We seek to provide a balanced view from the standpoint of an allocator. At Canterbury, we believe that hedge funds can play an important role in a diversified portfolio. In the short-term, investors may be captivated by sensational events, but in the long run, as famed investor Benjamin Graham put it, the market is a weighing machine. Far from being a game, the market rewards those with the skill and patience to invest in good companies at good prices.