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Hedge Funds Comeuppance

Hedge fund managers are far and away the wealthiest and most powerful operators on Wall Street. This is despite producing some of the worst overall results for investors. Their periodic eye-popping results offer great camouflage and encouragement that fantastic things are possible. Casinos operate on the same mindset.

Last week laid bare some of the risks of hedge fund investing.

Several funds were nearly obliterated last week on rising share prices of companies the hedgies were “short.” Shorting is the process of borrowing shares from other holders and immediately selling them. Shorting produces great results when those share prices fall and can be bought back cheaper, and then returned to the rightful owner. But crazy things happen when prices go in the other direction.

Shorting a $20 stock has a maximum return of $20 since stocks can only go to zero. But shorting a $20 stock has unlimited downside when the price rises.

The shorter loses 15x his original investment when the $20 stock goes to $300, as happened last week with GameStop stock. Buyers who have driven the price there will eventually lose because trading activity can temporarily cause the shares to trade at that price, but it cannot make a $20 company worth $300.

Be aware that Wall Street and hedge funds are big political contributors, and far more so than the tiny retail investors who have profited handsomely at their expense in this round. Political favors are likely already being called in, and trade stoppage has entered as regulators camouflage their own conflicts of interest with rhetoric about “protecting the little guy.” Maybe they mean the bankrupt hedge fund at this point.

I’m guessing this ends in tears all around as others pile on.

In the meantime, we remain focused on value and use strategies that neither bask in the glory of brief victories nor suffer the agony of defeat.

Read More: Smart Money? Maybe. Brilliant Money? Never.