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.
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.