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"If you do well in the market, it has to be because someone else is doing poorly."

Have you read Hayek? I think it's hard to discount the importance of information. The market is able to do some pretty amazing stuff -- like tell you whether we, as consumers, would prefer more online stores or in-person stores or search engines or ranches. It's not as if the balance between those demands is intuitively obvious, and it's hard to believe that knowing the answer isn't worth making a few snotty New Yorkers pretty crazily rich.

Not that this is why anyone does it. We're all out there to get rich, but for the most part it's hard to make money without somehow making the market more informative. If you're right, you make the transactions that say so -- and you can't make those transactions without pushing prices in the direction they need to go.

Well said. It's time the "zero sum game" myth was laid to rest.

I'm referring specifically to secondary stock markets. The buy-side generally deals in securities that have already been issued: the seller is another buy-side firm, not a firm that'll turn that capital into useful products. (There are exceptions, otherwise investment bankers wouldn't exist, but that's the bulk of the trading that goes on.) And the secondary market is zero sum - it doesn't produce anything, it just sets prices.

I suppose you could argue that more accurate secondary-market prices help allocate capital more effectively when firms make primary security offerings. That's how I sleep at night. ;-) But as far as I can see, the market is plenty efficient already. That's why index funds are so popular.

I also really dislike the moral-hazard problem inherent in the 2/20 compensation structure for most hedge funds. When hedge funds make money, they take 20% of the profits, a huge windfall for the fund. However, when they lose money, it comes out of the capital put up by the original investors. It's very much a "heads I win tails you lose" structure. The incentive isn't toward better overall performance, it's towards higher variability of returns.

A hedge fund that makes 25% and loses 20% on alternate years ends up being a wash for investors (minus fees), but it nets its manager an average fee of 2.5% for their 20% of profits (ignoring the 2% of assets). A fund that makes 10% every year, steadily, will end up being worth twice as much for investors after 7 years, but will only make its manager 2% yearly in profit fees. The incentive isn't towards higher performance, it's towards higher risk-taking.

I have to disagree: Hedge Funds usually take 20% of the profit above the High Water Mark, and above it only. Disclaimer: I'm working in a Hedge Fund with a 2/20 compensation structure, and I am leaving this very well paid job to start my own company, very far from finance, the Street, NYC, and actually very far from the United States...

Here is a little explanation (ignoring the 2% management fees, irrelevant for this discussion):

The fund starts at let say $100 per share. It makes 25% (before fees) the first year, so a share is worth $125. The manager takes 20% of incentive fees ($5/share) so each share is actually worth $120. Hence: the net performance for the first year is %20, and the new High Water Mark is $120 per share.

The second year the fund loses 16.6%, so now a share is worth $100. No incentive fees are taken. The high water mark remains at $120/share.

The third year the fund does 25% again (before fees). So now a share is worth $125. The fund charges 20% of incentive fees on $125-$120 = 5$, that is to .say $1. Hence the fund is now worth $124/share and that's the new high water mark, and the net performance for this year is 24%.

Conclusion: Year, Net Performance, Hedge Fund Fees.

1, +20%, $5/share.

2, -16.7%, $0.

3, +24%, $1/share.

I think that should be enough as an explanation to understand that the incentive is definitely towards higher performances.

Now in the real world, since investors get in and get out (and are trying to time this), it can be good to lose a bit to get some new investors on board... but that's psychology, not finance.

What if the fund makes 25% year after year for 5 years, loses 20% year after year for 5 years, and then all the investors pull their money out?

I chose alternating 25/-20% returns because they make the math simple. Very few markets actually behave like this: instead, you're likely to get 5-10 years of excellent performance, followed by 3-5 years of incredibly depressing performance. The numbers become harder to figure with this, but qualitatively, the conclusion remains the same.

In practice, hedge funds often do well while whatever they invest in is rising, and then "blow up" entirely when they start to underperform and investors run for the exits. Think LTCM or Amaranth, and it happens regularly on a smaller scale. The managers make hefty fees in the good times, and the investors are left holding the bag when the fund blows up.

Lots of hedge funds (the good ones at least) get out of this by requiring minimum investment periods. This prevents a focus of the LP's on short term gains/losses, but also prevents the run for the door.

It might be a friendly gesture to suggest a specific paper by Hayek that is to be read. I imagine you must have this one in mind:

http://www.econlib.org/Library/Essays/hykKnw1.html

That was what I had in mind, yes.

That feeling you get that it's "dirty" I understand well. I found the financial industry to be pretty disgusting in lots of ways, some subtle. Compared with creating new things for real people there's just no question which I prefer. Getting out pretty early was one of the smartest things I've ever done.

The financial industry is a huge prestige trap. It's hard for a young guy to give up a BMW M3 and million-dollar condo to work on an unpredictable startup. You can ask my friend and former partner :-)

"..it's a zero-sum game. If you do well in the market, it has to be because someone else is doing poorly. Either that, or the market is bubbling upwards ahead of a crash."

Man, this is a common fallacy. In the last 100 years the stock market index has gone up several orders of magnitude. How is this a zero-sum game? Or do you expect the DJIA to go back to 100 or whatever it started out at when this bubble pops? The world grows richer because people work and create value. There is stock market speculation, yes, but there is also genuine growth based on fundamentals.

Now it is possible that we are building up towards a more fundamental crash (peak oil, http://anthropik.com/2005/08/thesis-6-humans-are-still-pleistocene-animals , etc.). But I don't think you were talking about that. Perhaps it is all fundamentally zero-sum (http://scrapbook.akkartik.name/post/2025552, "Guns, germs and steel", http://www.newamerica.net/publications/articles/2006/the_return_of_patriarchy). But in the frame of reference where the stock market continues to function it is def creating value.

I guess I really explained this poorly. I don't mean that capitalism is a zero-sum game. I mean that the financial industry, and more specifically the buy-side firms dealing in secondary securities markets, is a zero-sum game.

The DJIA has gone from 89 to 15k because of the labor and ingenuity of American employees and entrepreneurs. New companies come out with new products, these products meet consumer needs, this creates value, this value is reflected in the company's earnings, and corporate earnings are reflected in the stock price. None of this happens because some quant sits at a computer and programs in mathematical models of prices. If Coca-Cola was still trading at 50 cents with its current earnings, everyone - financial professional or not - would be jumping on it. It wouldn't stay at 50 cents a share for long.

Some sort of stock market, with decent liquidity and abundant information, is necessary for proper functioning of the economy. But the stock market we have, where hedge funds colocate boxes on the exchange so that they can execute trades within milliseconds of new information coming in, is overkill. I think it's really sad that so many of the best and brightest minds are drawn into competing with each other instead of creating value for others.

I feel the same way about law, which is another necessary-but-zero-sum profession. It also tends to attract really smart people, perhaps because really smart people are used to being smarter than everyone else. The link to tournament economics that someone posted on another article here is quite appropriate.

Neither finance nor law are of necessity zero sum activities, although both of them may end up dissipating some wealth in some cases.

Financial markets are what enables society to direct capital toward its most productive uses, and every time you find an arbitrage opportunity, you have just contributed a little to that goal; think of it as Gosplan, except that it actually works. This is perhaps easier to understand in the context of markets in physical goods. A merchant who notices that the difference in the price of widgets in towns A and B is smaller than the cost of transporting them, and starts doing so, is obviously realizing a net gain for society. Stocks and bonds aren't all that different from widgets.

Good laws make it possible for people to rely on contracts with complete strangers, rather than always having to laboriously build up bonds of trust, and they prevent people from imposing costs on third parties that never asked for them. While bad laws may be bad, good laws exist too, and lawyers do occasionally get involved in making them work.

There is a distinction between making the laws and gaming them.

There's a lot of small-government rhetoric out there about minimizing legislation. The analogous point to about minimizing litigation is also plausible.

I had some ideas about translating open-source bugtrackers to legislation: http://reddit.com/info/79lo/comments#c7awp

Ah, I see. Thanks.

agreed. even warren buffet, arguably the best guy at this game, makes the same observation about trading.

very well put. I'd add accounting to that list as well, particularly something as burdensome as sarbanes oxley