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Joes vs Schmoes: Hedge Funds & Herds

“We have two kinds of people who lose lots of money: those that know nothing and those that know everything” – Howard Marks

I read this quote years ago and it has always stuck with me.  And given the recent investment clashes between hedge funds and the Reddit/Robin Hood (let’s call them R2) crowd, it couldn’t be more prophetic.  The societal consequence from Covid will be a fascinating case study for generations to come.  And the stay-at-home aspect has given rise to a new breed of investor.  Emboldened by Central Banks’ tailwind and ample free time, this nouveau class of ‘hedge fund’ managers don boxer briefs, not Brooks Brothers.     

The recent GameStop (GME) fiasco has played out more predictably than a Patrick Swayze movie.  Said stock gets run up from $20 to $450 in a few weeks by virtue of R2 chat rooms (we called them boiler rooms back in the day) only to raise the ire of Greenwich hedge funds who were short the stock.   Admittedly, I was kinda rooting for the Reddit rousers over the Ivy Leaguers fully expecting the blue bloods to exact their revenge.  And they have: the stock is back under $50 and falling daily.  The anatomy of a short squeeze and collapse:

Numbers aside, I find the R2 herding behavior far more fascinating than the Hedge Hogs (more on them later).  I would surmise most of them wouldn’t know a junk bond from James Bond. But confidence in sheer numbers should never be underestimated.  I revisited July ’18 Fiscal Fitness Crowded Out to audit the common herding denominators.  Let’s see how many check off:

  • The story is a can’t miss: think possibly Crypto today whereas it used to be or flipping Real Estate.  The R2 crowd think they have a formula:  find the most heavily shorted stocks and buy en masse.  This will force the shorts to cover to produce a parabolic short squeeze.

  • There is an inexplicable exponential run up in prices.  Yep, $20 to $450 in a few weeks would qualify.

  • Banks eagerly providing funding & liquidity.  Without question - given low interest rates.

  • Attracts full main stream media coverage.  Check.  CNBC even had a little box for in GME in the bottom right corner.   When my mom’s investment antennae (TMI) go up, it’s likely Tibetan Monks already know.  

  • The greater fool theory comes into play: we’ll timely sell to someone else at higher prices.   This is prevalent throughout the tech, pot, Crypto, SPACs, IPOs etc. areas of the market.  I chuckled hearing the Reddit ringleader directing his lemmings ‘not to sell until Tuesday’.  Please pass the Kool-Aid.  

  • The price volatility usually ends in tears and heavy losses.  Ask the non-binary investors who bought GME at $450 about this.  It remains to be seen in the aforementioned sectors.  

The Schmoes will likely end up learning very painful and expensive lessons when this market cycle ends.  Why?  Because the markets punish ignorance and, especially, hubris. Moving on to the Joes.

The Hedge Hogs are my favorite rodent.  Indigenous to the eastern sea board – particularly New York City and Greenwich CT. Has a reputation of high intelligence, questionable ethics and insatiable greed.  They have very short lifespans and are known to cleverly disappear when cornered.  Are these traits justified?  Let’s burrow deeper.  

These Joes manage large pools of money – anywhere from 10’s of millions to 10’s of billions.  The allure is promising superior returns thru exploiting market inefficiencies.  Usually reserved for accredited investors; these exotic funds will manage subprime mortgages, merger arbitrage, distress debt, artwork – you name it.  If they think they can find an edge, they’ll form a fund.  They usually have high investment minimums ($100k to as much as $100MM) in return for illiquidity, opacity, lack of regulation & mafioso fees.  Oh, and you can boast at the next socially distanced cookout.

Most importantly, do they consistently deliver on returns?  Not even close.  The chart below paints a grim picture.  Sure, there are occasional stellar performers but you and I ain’t invited to those parties.  In return for such lousiness, you get the pleasure of paying 2% and 20% of gains (2/20 in jargon terms).  Net of fees, it’s simply too difficult to provide superior performance.  The S&P Index handily outperformed the average Joe every year the past decade.  I might take my chances with the R2 gang after seeing this.

Back to the little spat:  the Joes simply kicked and screamed to their crony regulators that the R2 crowd ‘cheated’ – the House Committee on Financial Services has already begun grilling the Schmoes.  Actually, R2 beat them at their own game.  Hedge Hogs have been skirting the rules since inception – it is their caviar birthright to succeed.  The rest of us can eat crumb cake. 

My modest takeaways from all this:

  1. When things are going well, investors become greedy and enthusiastic.  It’s important to control emotions.  The best investors are agnostic and cold blooded.  I’d prefer to hit a lot of singles and doubles over the occasional grand slam. Think Tony Gwynn over Dave Kingman.

  2. Complicated investments are usually not worth the hassle.  Keep it simple and watch expenses.  I am fortunate to be armed with the TMI.

  3. FOMO is counter-productive.  Who cares what everyone else is doing? Social media has acerbated this.  Let’s face it:  there’s always going to be someone richer, smarter, stronger, faster and better looking than you and I.

Herds may be comforting to sheep and teenage girls; rarely to good investors.  Always question group think and avoid confirmation bias.  Understand yourself and your goals


Fiscal Fitness is a publication of Houlihan Asset Management, LLC for the benefit of its clients and friends. Houlihan Asset Management. Wealth Counseling/Asset Management. Copyright 2024.


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