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Buffet has said this about hedge funds for a long time now. Their fee structure incentivizes volatility, not long term performance, which is a bit ironic becaus

by adevine 10y ago

Buffet has said this about hedge funds for a long time now. Their fee structure incentivizes volatility, not long term performance, which is a bit ironic because the reason for the name "hedge" fund is that they should have the ability to do better risk management.

ajross 10y ago
Exactly. This is the real problem here, not the fairness of the fee structure. There is vanishingly little "small dollar" money in these funds. The median investor dollar in a hedge fund is a big player, and expected to be sophisticated about these things and to understand how the risks work. The harm is to the market as a whole, not the poor investors who get hurt in a down market.
- gozur88 10y ago
  How is this a harm to the market? There's nothing inherently bad about volatility.
  - ajross 10y ago
    Yes there is. Volatility is an inefficiency, by definition. Efficient markets seek to the correct market price and stay there. A "volatile" market is one where parasites (c.f. hedge fund maniacs) siphon off capital due to games like this.
tomp 10y ago
> Their fee structure incentivizes volatility, not long term performance Can you explain why?
- bo1024 10y ago
  Suppose the fund gets 2% of all profits in a profitable year and gets nothing in an unprofitable year. Scenario 1: 100 million dollar profits for two years in a row. Fund gets 4 million, customer gets 196 million. Scenario 2: 300 million dollar profit in the first year, 300 million dollar loss in the second year. Fund gets 6 million, customer ends up with -6 million.
  - bo1024 10y ago
    On a large scale, what this means is that the fund can look for large ups and downs because they gain every time there's an up, but they don't lose when there's a down. Now if you parallelize this (so it's happening at the same time with many different customers), it means they can focus on risky bets. Maybe half their customers will win and half will lose, but the fund makes money on the winners and isn't hurt by the losers.
  - Streeir 10y ago
    Most of the arguments in this comments sections are outdated. The same goes to the 'Buffet argument'. Most of the funds (after 2008) run with High-Watermark rule. Thus, in the case of your Scenario 2, fund will get nothing from the next 300 million it makes (apart from fixed fees). Thus, the investor will end up with 294 million at period 3. Just like if the fund made 100 million for 3 periods consequently.
    - Dylan16807 10y ago
      That applies if people leave their money in the fund forever. If some of that cycles then there are no high water marks on the new money.
    - kaleidic 10y ago
      Quite right, though the high water mark approach predates 2008.
- deleted 10y ago
  [deleted]
- titanomachy 10y ago
  The article sums it up pretty well. If the fund goes up and down a lot, the managers make money in the up years but don't lose it in the down years.
  - tomp 10y ago
    The article is wrong. See the other comment about High Water Mark. Long-term the fund only takes the profit on the total return.
    - lordnacho 10y ago
      The problem with the high water mark is there's then an incentive for managers of deep underwater funds to close them and open new ones.
      - tomp 10y ago
        That's an incentive of any business owner that loses money. It's the duty of investors to review the managers reputation and not give money to known "fraudsters" (unless they can negotiate an incentive structure to prevent such problems).
        lordnacho 10y ago
        How so? If you're running a widget factory, you can't just close it and open again with the same machines and staff under a new name. Your investors would have good reason to sue you. And in any case you're not paid a proportion of your shareholder's returns. With a fund, which is a separate vehicle advised by a management company, the fund can be closed with the knowledge (typically code, and who is gonna know if you take that?) kept and used to run another fund. And it needn't be terribly blatant. If a guy has a reputation as a stock picker, he can do something like open a new fund for another geography or sector. Investors can be strangely loyal, too.
        lisper 10y ago

by adevine 10y ago

ajross 10y ago

Exactly. This is the real problem here, not the fairness of the fee structure. There is vanishingly little "small dollar" money in these funds. The median investor dollar in a hedge fund is a big player, and expected to be sophisticated about these things and to understand how the risks work. The harm is to the market as a whole, not the poor investors who get hurt in a down market.

gozur88 10y ago
How is this a harm to the market? There's nothing inherently bad about volatility.
- ajross 10y ago
  Yes there is. Volatility is an inefficiency, by definition. Efficient markets seek to the correct market price and stay there. A "volatile" market is one where parasites (c.f. hedge fund maniacs) siphon off capital due to games like this.

tomp 10y ago

> Their fee structure incentivizes volatility, not long term performance Can you explain why?

bo1024 10y ago
Suppose the fund gets 2% of all profits in a profitable year and gets nothing in an unprofitable year. Scenario 1: 100 million dollar profits for two years in a row. Fund gets 4 million, customer gets 196 million. Scenario 2: 300 million dollar profit in the first year, 300 million dollar loss in the second year. Fund gets 6 million, customer ends up with -6 million.
- bo1024 10y ago
  On a large scale, what this means is that the fund can look for large ups and downs because they gain every time there's an up, but they don't lose when there's a down. Now if you parallelize this (so it's happening at the same time with many different customers), it means they can focus on risky bets. Maybe half their customers will win and half will lose, but the fund makes money on the winners and isn't hurt by the losers.
- Streeir 10y ago
  Most of the arguments in this comments sections are outdated. The same goes to the 'Buffet argument'. Most of the funds (after 2008) run with High-Watermark rule. Thus, in the case of your Scenario 2, fund will get nothing from the next 300 million it makes (apart from fixed fees). Thus, the investor will end up with 294 million at period 3. Just like if the fund made 100 million for 3 periods consequently.
  - Dylan16807 10y ago
    That applies if people leave their money in the fund forever. If some of that cycles then there are no high water marks on the new money.
  - kaleidic 10y ago
    Quite right, though the high water mark approach predates 2008.
deleted 10y ago
[deleted]
titanomachy 10y ago
The article sums it up pretty well. If the fund goes up and down a lot, the managers make money in the up years but don't lose it in the down years.
- tomp 10y ago
  The article is wrong. See the other comment about High Water Mark. Long-term the fund only takes the profit on the total return.
  - lordnacho 10y ago
    The problem with the high water mark is there's then an incentive for managers of deep underwater funds to close them and open new ones.
    - tomp 10y ago
      That's an incentive of any business owner that loses money. It's the duty of investors to review the managers reputation and not give money to known "fraudsters" (unless they can negotiate an incentive structure to prevent such problems).
      - lordnacho 10y ago
        How so? If you're running a widget factory, you can't just close it and open again with the same machines and staff under a new name. Your investors would have good reason to sue you. And in any case you're not paid a proportion of your shareholder's returns. With a fund, which is a separate vehicle advised by a management company, the fund can be closed with the knowledge (typically code, and who is gonna know if you take that?) kept and used to run another fund. And it needn't be terribly blatant. If a guy has a reputation as a stock picker, he can do something like open a new fund for another geography or sector. Investors can be strangely loyal, too.
        lisper 10y ago