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> it may create a very little value by increasing market efficiency a bit, but mostly it's playing a zero-sum game. How would you go about quantifying that? Ma

> it may create a very little value by increasing market efficiency a bit, but mostly it's playing a zero-sum game. How would you go about quantifying that? May it not be the case that gains from market efficiency increases far outweigh the "cost" of hedge funds?

gjm11 10y ago
It certainly could be, in principle. I don't think I've ever heard anyone seriously claim that they actually do, though. I'm not sure why the scare-quotes around "cost"; there obviously is a cost, typically "2 and 20". So the effect of the hedge fund is: it plays the zero-sum game and thereby redirects money (say an amount x) from a bunch of other market participants; the investors pay their 2-and-20 fees (call the amount c); the hedge fund is doing well and x>c so the investors are happy. Those other market participants are losing an amount x (relative to what they'd have had without the hedge fund) because the game is zero-sum; of course they are not happy, but who cares about them? (Actually, they might be happy -- the effect the hedge fund has on them is probably small, and if the market is generally doing well they'll doubtless feel fine. But they'll be worse off than they would have been without the hedge fund in the market.) It's worth being a bit careful about who loses out and how. It typically isn't the other parties the hedge fund trades with. (Consider a case where the hedge fund predicts that an asset will increase in price, buys it from someone else, and sells it later at a handsome profit. Have they harmed the person they bought it from? No; they would have sold it anyway, and they'd have got a lower price for it.) The losers are all the other people who are making trades similar to the hedge fund's, and have to accept very slightly less favourable prices because the hedge fund is making the same trades as they are. So, e.g., if you expect that Apple stock is going to go up and buy some, and if some hedge fund with cleverer people and faster computers and (don't say this too loudly) more inside information has made the same prediction before you did, then you will be paying a higher price because of the hedge fund's activity.
- davidivadavid 10y ago
  Sorry, missed your answer. The scare quotes around "cost" are just to underline the negative connotations in the term. If it turns out their are large overall gains from their activity, I feel it would be a bit disingenuous to talk about their "cost" if they're bringing more value to the economy than they're taking away. Anyway, I don't think your analysis is sufficient to answer my question. There are second order effects beyond what happens to people involved in the trading of securities. Better market efficiency means better pricing of securities, which has effects on the returns of equity financing, which in turn could mean higher growth at a higher level. To be fair, it's a pretty complex question and I wasn't expecting a precise answer, but references to papers that might have been written on the subject would have been interesting.

gjm11 10y ago

It certainly could be, in principle. I don't think I've ever heard anyone seriously claim that they actually do, though. I'm not sure why the scare-quotes around "cost"; there obviously is a cost, typically "2 and 20". So the effect of the hedge fund is: it plays the zero-sum game and thereby redirects money (say an amount x) from a bunch of other market participants; the investors pay their 2-and-20 fees (call the amount c); the hedge fund is doing well and x>c so the investors are happy. Those other market participants are losing an amount x (relative to what they'd have had without the hedge fund) because the game is zero-sum; of course they are not happy, but who cares about them? (Actually, they might be happy -- the effect the hedge fund has on them is probably small, and if the market is generally doing well they'll doubtless feel fine. But they'll be worse off than they would have been without the hedge fund in the market.) It's worth being a bit careful about who loses out and how. It typically isn't the other parties the hedge fund trades with. (Consider a case where the hedge fund predicts that an asset will increase in price, buys it from someone else, and sells it later at a handsome profit. Have they harmed the person they bought it from? No; they would have sold it anyway, and they'd have got a lower price for it.) The losers are all the other people who are making trades similar to the hedge fund's, and have to accept very slightly less favourable prices because the hedge fund is making the same trades as they are. So, e.g., if you expect that Apple stock is going to go up and buy some, and if some hedge fund with cleverer people and faster computers and (don't say this too loudly) more inside information has made the same prediction before you did, then you will be paying a higher price because of the hedge fund's activity.

davidivadavid 10y ago
Sorry, missed your answer. The scare quotes around "cost" are just to underline the negative connotations in the term. If it turns out their are large overall gains from their activity, I feel it would be a bit disingenuous to talk about their "cost" if they're bringing more value to the economy than they're taking away. Anyway, I don't think your analysis is sufficient to answer my question. There are second order effects beyond what happens to people involved in the trading of securities. Better market efficiency means better pricing of securities, which has effects on the returns of equity financing, which in turn could mean higher growth at a higher level. To be fair, it's a pretty complex question and I wasn't expecting a precise answer, but references to papers that might have been written on the subject would have been interesting.