So, let’s talk about hedge funds.
Beating them is easier than you think. The HFRI 500 Fund Weighted Composite Index, which tracks the largest 500 funds, has a five-year annualized return of 5.6%. The SPDR S&P 500 ETF Trust has a five-year annualized return of 15.1%. Other S&P 500 index funds—both in mutual fund and exchange-traded fund (ETF) formats—have similar returns. Lest you think I cherry-picked this period, consider that Warren Buffett handily won a $1 million bet over a hand-selected group of hedge funds in 2017. How did he do it? He chose to hold an S&P 500 index fund for 10 years starting in 2007.
But let’s say you are an active investor. Well, use your advantages of being an individual investor. One of those advantages is never having to report performance. Hedge funds have to answer to their clients. This often leads to short-term thinking. You don’t have to report to anybody. This gives you the ability to follow long-term strategies and not worry about quarterly or annual performance. It’s a big advantage.
You also have the advantage to invest in whatever stock you want. While this may not seem like a big deal, it is. Many hedge funds—along with many other institutional investors—are restricted by their sheer size. It’s much easier to allocate, say, $20,000, $500,000 or $1 million than it is to invest billions (hedge funds) or trillions (large asset managers). Even an individual investor with a small amount of cash in their Robinhood account can buy stocks that are essentially off-limits to most hedge funds.
The universe of stocks to choose from is bigger than you may realize. Now think about how many stocks you actually hear about with any frequency. I haven’t seen data with exact numbers, but a reasonable estimate might be 10% of the 4,000. If we leave out the one-off mentions—where a stock makes the news headlines for a single day and then fades back into the background—it’s possible this estimate is too high. Even among S&P 500 companies, there are those that are unfamiliar to many. Everest Re Group Ltd. (RE) and Teleflex Inc. (TFX) are likely among such large-cap stocks.
The point is that the circle of potential investment candidates and the circle of the stocks you hear about are different. Is there overlap? Absolutely. Being ignored doesn’t make a bad stock a good investment, just as receiving attention doesn’t make a good stock bad. Limiting which investments you are willing to consider does, however, increase the odds of missing out on potentially good investments.
Furthermore, many of those stocks are not even on the radars of most hedge funds or institutional funds. Yes, some hedge funds might take an interest, but they simply can’t invest in or short everything. They need stocks to be a certain size and have a certain level of volume. The minimum size and volume requirements are far greater for hedge funds than they are for us individual investors.
You, of course, are not limited to small stocks. We individual investors are not bound by any size constraint. So, we can look at big and small stocks in terms of market cap. We can also hold for longer time periods and target our strategies to reach personal goals instead of having to worry about pleasing clients.
All of these advantages allow us to invest differently than the hedge funds do. Often, the way to win is to simply not play the same game.
Recent Broker Issues
I’m admittedly going a bit long with this week’s commentary, but I wanted to address the issues affecting some brokers last week.
The combination of extraordinarily high volatility and high trading volumes caused Robinhood to restrict trading in certain securities, including GameStop. The broker—which primarily makes its money from how it routes orders to market makers—was not adequately capitalized to handle the volume. In simple terms, the issue stemmed from the difference between when trades are placed and they settle. The market makers demanded more collateral from Robinhood to avoid incurring losses.
Problems and restrictions were not just limited to Robinhood last week. Access to TD Ameritrade’s mobile app was limited because of the high trading volumes. The firm also raised margin requirements on certain stocks, as did TD Ameritrade's recent acquirer, Charles Schwab. The Wall Street Journal listed E-Trade, Interactive Brokers and Webull Financial as also having placed restrictions on trading.
Lawsuits have been filed against Robinhood, and the U.S. Securities and Exchange Commission (SEC) is looking into last week’s actions by brokerage firms. The restrictions caught many investors off guard, but the scope of the problem should be kept in perspective. The overwhelming majority of investors who weren’t trading in the affected stocks (or solely relying on TD Ameritrade’s app) probably didn’t notice much in terms of issues. Still, it’s good to see regulators paying attention to the issues.
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