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Retail Traders Knock Out Hedge Funds… Place Bets on Round Two with New Play

Years ago, being a hedge fund manager was something worth bragging about – I would know.

Starting in 1983 on the floor of the Chicago Board of Exchange, I ran multiple successful hedge funds, helping clients (and myself) make beaucoup bucks in the stock market. At times, I was outright braggadocios about my successes, like many other hedge fund managers. Some even beat out the yearly gains of the stock market year after year…

But that was ages ago, and hedge funds aren’t bragging anymore.

It’s retail – small traders and investors – that ought to be celebrating success, and I’ve got a new play so you can be celebrating the very same profits.

Book Smart vs. Street Smart

The biggest difference between hedge fund managers and retail traders boils down to smarts.

Hedge funds utilize things like higher math, computer-driven modeling, quantitative analysis – methods of trade management that require lots of money or a college degree to pull off. These “book smarts” did well by hedge funds for decades and kept retail out of the markets. The prevailing wisdom was that book smarts work, nothing else.

But even with all that money, analysis, quantitative firepower, and (sometimes) inside track information, hedge funds sucked wind in 2021. Pension & Investments, which measures average hedge fund performance, found that they only returned 10.3% gains to their clients that year.

Meanwhile, retail made leaps and bounds over hedge funds – no formal education required.

Using the web equivalent of “street smarts” passively through mutual funds or an S&P 500-tracking ETF like SPY, retail would have raked in a 26.89% gain last year. Including the dividend payouts, that’s a total return of 28.71%. Gains like that using retail trading methods were previously unheard of – and miles ahead of hedge funds.

Take a look at the numbers yourself. The chart on the right was courtesy of the Financial Times. Only three hedge funds beat out retail in 2021.

But that 28.71% return is just an estimate. Not all retail traders are as passive. They’re becoming increasingly active in how they choose their trades using “street smarts.” Their social, or para-social, connections. Think of meme stock trends, the comradery of helping squeeze institutional shorts, or engaging with influencers on Reddit, Twitter, Discord, or the hundreds of other social media sites and apps. With these methods by their side, retail may be more active than its Wall Street counterparts that are stuck in their traditional “book smart” ways.

Hedge Funds Missing the Point

Managers once bragging about their successes are now shaking in their boots, desperate to find a way to keep up with retail. But in all their efforts, hedge funds are missing the obvious answer: a company’s individual earnings prospects no longer carry its stock’s weight.

Notably, since 2008, profitable stocks have moved in lockstep. These are hot momentum stocks that are covered in the press, on financial networks, that retail traders and investors chase precisely because of their fame. I’m talking about the likes of FAANG stocks, Microsoft and Tesla, and other narrative stocks with a story behind them.

Hedge funds are too caught up with trying to find the needles in the haystack – needles that outperform the rest.

Retail trades the haystack. And it works. It’s how they beat the pros at their own game. It’s why active ETF managers are trading into popular stocks that trade in lockstep just like them. That creates more momentum, which attracts more retail interest – creating a positive feedback loop called “lockstep trading.”

Hedge funds are now piggybacking off of retail’s moves. You can see it in the best-performing hedge fund in 2021 – Senvest Management, run by Richard Mashaal and Brian Gonick. The $3.3 billion fund outperformed all the hedge funds last year and clobbered the average return with a staggering 75% return.

How’d they manage it? Retail traders. In addition to following smaller retail trends, they placed a big bet that GameStop’s price would jump, and we all know how that went last January.

That’s the key to outperformance: follow the retail crowd and hang on for the ride.

One simple way to do that is by placing a block of your investment capital in an indexed ETF like SPY, so you capture the market’s long-term up trending bias and manage the rest by allocating pieces to what retail traders are getting into.

That doesn’t mean you load up on crazy meme stocks or hold bankrupt companies like Hertz. It means you trade into those types of stocks as early as you can, use fairly tight stops, say 10%-15%, and trade out of them on the way up, so you’re selling at higher and higher prices.

You don’t have to try and capture the whole ride, though at times that would-be killer. It’s just next to impossible to do that. That’s why you always “ring the register” when you have appreciating gains. Take pieces off as your positions appreciate, and just smile if they end up going a lot higher or tumble back to earth.

Making money isn’t as hard as hedge funds make it sound – it’s about wagging your tail and chewing on that bone.

Go get ’em,

Shah

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