Shouldn’t we invest like Hedge Funds?

Hedge funds are said to be the cream of the crop, the titans of the investing world. They are the only geniuses that can generate outsized returns for their wealthy investors. Why shouldn’t retail (average) investors like you and me invest in the stocks they invest in? After all, you can find their latest stock holdings on the internet and in quarterly reports on the SEC’s website. We should all be investing in what they invest in, right?!

Wrong.

Sophistication

There is a big information gap between what hedge funds know about a stock and what we know. The gap is huge. Hedge fund analysts track the markets all day every day; it is their job! However, it is not mine (and likely not yours).

Hedge funds can also afford to trade large amounts of money that I simply cannot. To put it in perspective, hedge funds only take money from “accredited investors.” To qualify as an accredited investor, you would need a net worth of at least one million dollars and an annual income of around a quarter of that.

Most retail investors oversee thousands of dollars.

Another major consideration is that hedge funds are closer to the action than we are. They attend meetings with company executives, board meetings and can even make decisions about the future of the company (when they buy a considerable stake in the company). You and I do not have that ability because we cannot afford to buy a large enough stake for the company to care about our opinion. Most hedge fund managers who hold positions such as these buy hundreds of millions of dollars’ worth of the company’s stock; my five shares don’t mean much

Legal

While being close to the action is a great advantage for the sophisticated investor, it can also make things very complex. In order to trade any securities (usually stock in the company) the fund manager can only trade off of public information. If the hedge fund hears or receives any nonpublic material information from the company, they are in deep trouble if they trade based off of that information.

If a hedge fund manager has bought a block of shares before an important exclusivity meeting, eyebrows will be raised.

Thankfully, this isn’t a great concern for us, at least, until recently!

Risk

A majority of the hedge funds out there employ leverage. Leverage increases a position’s risk significantly and should be applied sparingly if at all for investors like you and me. However, this is one the ways hedge funds make so much money when they are right. For example, a fund that employs a leverage ratio of 5:1 means that if their stock position goes up one dollar, they actually earn five dollars. The same applies for when the stock goes down sadly; you would lose five times more than without leverage if the stock went down one dollar. Hedge funds can typically afford to use leverage and are well equipped to handle major losses if their position turns; I do not have that luxury.

Hedge Fund Strategies

Novices tend to overlook the fact that hedge funds have many other profitable side strategies. Aside from investing in stocks traditionally (holding them for the long term), many if not all hedge funds have a handful of supplemental strategies. It’s ok to look at stocks in a fund’s portfolio but it is vital to know how they are using that stock in their relative strategy.

For example, many hedge funds run a merger arbitrage strategy where a hedge fund buys stock in a company that is being acquired and short sells (bets against) the acquiring company’s stock. If you were not aware that the company being acquired was about to be eaten up by a parent company (and the acquired company stock ticker will soon no longer exist) you could find yourself overpaying for a stock that is about to vanish.

Another more common example is buying stocks that quantitative hedge funds buy—this is a hard pass. Quant funds buy and sell stocks within a matter of milliseconds to eke out any small profit. They also don’t have to worry much about commissions and the tax implications that we do. It is important to mention that these funds use million-dollar machines that are monitor obsessively. We can’t afford that!

If you are going to base your decisions on what hedge funds buy, you must be aware of the rationale of their actions. Don’t trade based off of actions alone.

So, should you invest in Hedge Fund Stocks?

The short answer is no. It is always better to do your own research on companies. While listening to analysts can give you ideas, you need to ask yourself if they’re selling something worth buying. Hedge funds have far greater intel on stocks. You need to make sure that you are looking out for your best interest as they are looking out for their best interests.  

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