- Capital Gains
- "Real Money" Investors and Everybody Else
"Real Money" Investors and Everybody Else
Why Some Investors Matter More Than Others
Sometimes we’ll contrast the behavior of "real money" investors with "hot money" or "fast money" investors. It’s one of those odd mental models where it's mostly useful because it draws a theoretical distinction and then blurs it in practice. In theory, the distinction is that real money investors have a default holding period between indefinite and forever: if they buy something, they expect to get their returns from dividends or from an acquisition, not from doing a quick flip. This is contrasted with hot money investors, who are betting on a short-term change in sentiment that will change asset prices.
While these investors have a completely different approach, it doesn't make sense to treat them as different populations, because in practice, hot money can sell to one of two kinds of parties: a different hot money investor, or a real money investor. So they have to think alike. In fact, the distinguishing factor might be that real money investors are modeling the business and checking to see whether or not the price is good, while hot money investors are modeling the real money investors' model of the business and asking how it will change.
Another distinguishing factor is less about how they think and more about how they operate. A real money investor knows they'll be stuck with a pick for a long time, so they can do a very deep research process. They also know that, because of this timeline, any given quarter is not that important; you wouldn't pile into a stock today because you think it'll be up 5% on earnings if you had to hold it for five years—that's an incremental return of under 100 basis points per year, compounded, and only if you got the call right!
But it’s not just about individual investors; the model can be extended further. Company management can count as a real money investor, both in the direct sense that management will buy and sell (mostly sell) shares in the company they work for, and because the company will issue or buy back stock. Their incentives aren't perfectly aligned with stock price maximization, of course. A CEO who holds on to the bulk of their stock over time is capturing the rewards for good management, but they're also buying insurance against the social penalty from bad management (i.e. the board of directors promoting them to non-executive chair and putting someone more effective in the CEO seat). This factor is more common with dual-class stock, where a manager can minimize their economic interest while retaining voting control and thus their high-status job and its attendant pay. Issuing and repurchasing stock might be the most real money transaction possible, since it literally sets the supply of stock that is matched by demand from purely financial investors. Private equity firms and other acquirers are also mostly in the real money camp, as they, too, can't quickly adjust positions based on incremental news flow, or try to get ahead of a near-term shift in sentiment.1
One thing the real money versus fast money distinction affects is companies' shareholder communications. At any given time, a public company in the US will usually have index funds as its largest holders, followed by a smattering of hedge funds and long-only (i.e. real money) funds. When the company meets with investors, it wants to talk to those real money funds—they know the business better, if they own the stock this quarter they'll still own it next quarter, they're getting meetings with the management teams of competitors, and, anecdotally, they are at least more discreet about checking their email and/or the stock price during the meeting. They also tend to ask deeper questions: a long-only investor in Netflix is probably deeply curious about what the long-term economics of licensing streaming content look like, or how broadband versus mobile will evolve in the developing world. Whereas hot money investors often ask scintillating questions like "is your operating margin guidance TK rounded to the nearest percentage point, or the nearest half-point? What was the pace of growth exiting the quarter? How far along is your password-sharing crackdown—by country, thanks?"
Unless the company's representative happens to be one of those people who takes pride in knowing the fiftieth-most-important business metric to one more significant figure than really matters, these questions are exhausting. On the other hand, hot money pays a lot more commissions, so the banks who arrange these meetings typically want plenty of hedge funds at the table. To take this a step further, even though every party feels like they're getting a slightly bad deal—investors sitting through questions they're not interested in, companies pitching to investors they know may be out of the stock in a few weeks—the whole event only makes financial sense because of the commissions hot money investors pay. So there's a weird symbiosis, where real money investors get more research and more management access by free-riding on the revenue generated by shorter-term hot money traders, while those traders get to talk to management teams that wouldn't be especially excited to meet with them. The whole situation has more in common with the economics of nightclubs than any participant would care to admit.
The symbiosis doesn't end there. Real money investors are the ultimate price-setters, because they're the ones who are making trades that won't be reversed in a short period. Conversely, the reason we sometimes call hot money fast is because it’s, well, fast: their strategies usually require high turnover, and often use enough leverage to force high turnover when positions don't work out. From the real money perspective, fast money just adds noise: stocks that are working overshoot, and earnings disappointments have a wildly exaggerated impact when they affect companies that hedge funds have crowded into.2 But the flip side of this is that the entire job of fast money investors is to predict what real money investors will think in the near future. The basic model is to figure out what multiple they will be willing to pay for something, and then get a better sense than they have of what the multiplicand is. Or, occasionally, to make the case that the multiple itself will change.3
The paradox of this distinction is that the real money investors are the most fundamentally-oriented—they really are trying to buy good companies at good prices.4 But if you define "fundamentals" as the quarterly numbers a company produces, the fast money types will tend to spend much more time on those, and will generally predict them better, at least for the next few quarters. So the fast money types end up caring more about the numbers, even though the same approach for the same company can apply when it's trading at 10x earnings or 50x—the effect of a 5% increase in forward-year earnings expectations is about 5% in either case.
This piece describes these groups as two different groups, and to some extent there's selection for particular personality types in different strategies. But in practice, there's a reasonable level of talent flow between these two styles, and funds that mostly focus on one can end up doing a bit of the other. (A fast money investor will run out of capacity after a while, and will notice over time that they've been buying the same company ahead of earnings every single quarter, and missing lots of intra-quarter moves in the right direction. Meanwhile, for real money investors, there is still some benefit to timing transactions; if you're going to take a material position in a company, and you also know the company well enough to sense ebbs and flows in their progress, you can at least adjust positions and change the timing of your purchases to pick up some extra alpha.)
One set of investors is mostly focused on making a prediction, and the other on predicting someone else's prediction, but both of these methods require the practitioner to figure out true, important, and misunderstood things about the state of the world.
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Read More in The Diff
The real money / hot money distinction has shown up in a few different Diff artiles. For example:
This piece ($) looks at multistrategy funds (the canonical hot money investor) and how they’ve moved from a more artisanal, craft-style model to a business that reliably manufactures uncorrelated excess returns.
One distinction between real money and hot money is leverage. Borrow enough, and your holding period is constrained by margin calls. That’s what happened to Archegos, the briefly massive growth-focused family office.
“Every Investor is a Market Maker” ($) is a model that works as a useful reminder—every trader is in some sense an uninformed trader, and making money partly comes from recognizing where you should expect to lose.
“What We Talk About When We Talk About Stocks.” There are also mutually-incompatible models for what an investment in a stock actually is. These models vary in intellectual purity, but they all tell you something.
1. An exception here is small-scale acquisitions where a company is paying some amount for the business and some amount to say "We are definitely involved in Hot Theme XYZ. When a small AI company sells to a small public company, the acquisition is basically a very expensive press release.
2. It's entirely possible that this is a material source of alpha for long-only funds; if they can add to a position or trim it a bit when there are wild hedge fund-driven swings, they're both taking an opportunity to amortize the cost of research over more trades and providing liquidity when it's scarce.
3. This is harder because there won’t be a concrete catalyst. If a company is valued based on revenue, and you do more channel checks than anyone else, you may know the revenue number better than anyone else. But there aren’t channel checks or alternative data sources that can tell you when the market will reassess what multiple a company should trade at, or whether it should be valued more based on a profit or cash flow metric than revenue.
4. Or incredible companies at semi-defensible prices, or mediocre companies at truly absurd prices.
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