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.

Fundamental vs. Tactical Strategies

The first lesson is to understand the interaction between fundamental and technical strategies:

• Fundamental strategies focus on companies’ business fundamentals.
• Technical strategies focus on trading patterns in stocks.

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.

Impact on Hedge Funds

Next, here are some ways that hedge funds may be affected going forward, based on numerous conversations we have had with fund managers:

1. We expect to see less willingness from managers to disclose their short positions in letters and conversations. This would prevent them from being targeted by buyers attempting to force stock prices up. It is now even more important to establish strong relationships with managers when performing due diligence.
2. We have been observing a hesitancy to short names with lower liquidity and high short interest (percentage of share outstanding that are “sold short”). Even though they are finding declining businesses, many managers have dialed back their short positions to protect themselves from the risk of short-term losses.
3. This episode has brought the controversial practice of payment for order flow (PFOF) back into the crosshairs of lawmakers. PFOF refers to the benefit a brokerage firm receives for directing trades to a different party. In February, the CEO of Robinhood, a popular retail trading platform, testified before congress regarding this practice, which accounts for around 50% of the firm’s profits. While a deeper dive into PFOF is outside the scope of this post, any potential regulation would impact funds that utilize technical strategies such as high-frequency trading (HFT). Fundamental strategies would not be directly impacted.

Importance of Hedge Funds

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:

1. The hedge funds’ ability to short stocks, under normal circumstances, provides signaling to capital markets. If a stock price is too high, it will tend to be sold short and come down. As we’ve seen in the case of GameStop, when hedge funds (voluntarily or otherwise) withdraw from shorting a stock, a group of determined buyers can temporarily inflate its price dramatically. Ultimately, this hurts retail investors who buy in too late.
2. Hedge funds provide a source of potential returns for investors regardless of the market’s direction. By being able to go long on stocks they believe are undervalued and short stocks they believe are overvalued, a hedge fund can earn returns unavailable to traditional long-only managers.

Conclusion

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.