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Why do we need hedge funds and traders?

15 points by bordemje ↗ HN
Hi. My question is related to the stock market.

Warren Buffett argues that active investing doesn't make sense because it loses out to passive investing in the long run. I agree with this.

I also agree that there are profitable strategies based on arbitrage, but this requires ultra-fast computer bots. (I assume that this is the main strategy of James Simons). This strategy requires very serious competence, so it also does not make sense for an ordinary investor.

But the question arises: why do hedge funds and traders exist if active investing does not make sense? What is their meaning, if it is much more profitable for any player to deposit money in SPY (S&P500)? Is this some kind of big scam, or am I missing something? Or the top hedge funds just manipulate the market for profit?

23 comments

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Bostonian
There probably are too many hedge funds and actively managed mutual funds out there, because managers are overconfident (and paid to be) and because investors are overconfident in their ability to pick funds. That said, there are markets much less liquid than the stock market. For example, when a company goes bankrupt, eventual partial recovery can take years. Hedge funds will buy claims from creditors at a discount. Those claims don't trade on an exchange. Much of the bond and real estate markets is not traded on an exchange.
subject4056
In order for passive investing to produce returns, stocks need to be regularly priced. Active trading produces the prices.

Active traders are trying to beat one-another, but at an institutional level the point isn't to beat the market, but to make the market.

caspercrf
This is true, and there are many strategies that hedge funds use besides just buy(long) or sell(short) the market. High frequency trading is one, another is spread trading. With spread trading, you take 2 stocks that are highly correlated to each other, let's say Ford and GM. You buy one, and you short the other. You are technically market neutral, so if they both go up or down, you are still break even. When the 2 stocks start trading closer or further apart by a couple of standard deviations, you can put on a trade that bets the 2 stocks will revert to the mean of their historic ratios.
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thagerty
Wow. Keep your last question, turn it into an emphatic statement, and throw away the rest. Your education begins today. If you'd ever had a share of something the hedgies decided to short into oblivion, you would understand this.
wmf
There's a theory that hedge funds got great returns in the 1990s from legal non-public information which was banned by Reg FD in 2000. Many investors may not realize this and are still putting money into hedge funds even though their returns have been mostly poor since 2000.
metadat
Fascinating. Do you have any references to read further on this subject?
jklein11
I would say there are two ends of the spectrum.

On the idealistic side:

The market for equities is enormous. Making it work requires some blunt instrumentation. This creates inefficiencies that hedge funds exploit. These exploitations make the overall market more efficient and make the hedge funds money.

On the skeptical side:

Hedge funds charge 2% of AUM and 20% of returns. They use some of these profits to market to investors and convince them that they are the smartest people in the room. They keep the fund afloat as long as they can until they need to raise another round.

I think the reason why hedge funds exist is somewhere between the two.

DLA
The market needs a variety of participants operating on different strategies across different time horizons with different risk tolerance levels to enable price discovery and liquidity. If everyone (loosely speaking) were buy and hold and active trading was vastly curtained market liquidity would be hurt. The heterogeneous nature of market participants makes for a healthy, vibrant, and liquid market for all. [former registered market professional]
aristofun
They exist to provide services to fools and make money on comissions.
hello_computer
Say I owned a small restaurant that consistently brought in $14k/mo. Tired of managing it personally, I hire a manager, and give him a checklist of responsibilities. Revenue plummets from +$14k to -$2k. I workshop it, coach the new guy, next month rolls by: -$2k again! I might give him another month or two, but sooner or later, I'm going to fire the guy and find someone else. All very rational and straight-forward. But now that most of the wagies have their pensions automatically piled into vanilla funds, this isn't how it works at all.

Imagine that one of these vanilla funds now owns 100% of my restaurant. Even though they own 100% of it, the restaurant only makes up 0.1% of their portfolio. They aren't going to bother with troubleshooting anything. They will either hold on to it, and keep eating those losses, or they will sell it at a loss and move on--while dipshit manager keeps running the restaurant into the ground.

One nice thing I'll say about a hedge fund is that I will occasionally see one jump-in and sort out such a mess, if only because they were the ones left holding the bag. The large stakeholders are the only ones making the market behave in a semi-rational manner. If it were up to the retail investors, it would be 100% propaganda and noise--the ouroboros--buying at 1000 P/E while huffing Zuck and Elon's farts.

TheAlchemist
Those are 2 different questions I think: - hedge funds - on average they underperform indeed. But ... people always think they can pick one that will outperform the others. Go figure ! On the other hand, there are some - like Buffett that you cited, that did outperform indexes over very long periods of time. Also, there are actually hedge funds consistently making money - they are mostly algorithmic stuff, not really stock picking.

- traders - if you ask about day traders, then we absolutely don't need them. What's happening now with those 0 day expiry options and other shit, is historically unprecedented. It will end very badly. The banks and some hedge funds do need the traders though - the real ones. In the end, you need humans to execute the trades, or at least program / configure the bots.

seydor
legal form of gambling
Spooky23
Active investment doesn’t make sense for you. It does for others who may have different aims.

Think of the needs of someone with a big pile of unrealized gains. You don’t want to sell and create tax events, but borrowing money and using shorts or options to address short term risk might make sense.

ldjkfkdsjnv
Efficient allocation of capital, very simple, and arguing hedge funds arent needed literally makes no sense. The efficient market hypothesis is obviously false, its just that most hedge funds are scams
philomath_mn
Active investing probably doesn't make sense for _you_ as an individual, but a sophisticated hedge fund with a good team and good data can definitely find competitive edges. That being said, some hedge funds and other wealth managers (cough - VCs cough) are definitely border-line scams riding on leveraged beta exposure (wasn't a bad strategy during ZIRP).

I'm not sure day traders (a) are a large enough force to affect markets or (b) ever make all that much money on average.

mo_42
Maybe some clarification: strictly speaking, there is no passive investing. Every investment requires some form of action. Also, investing in an MSCI ACWI is active in some sense because the shares of shares change over time. I accept passive investing in the sense that people don't analyze their investments extensively and invest in some weighted set of stocks and accept the market rate.

> But the question arises: why do hedge funds and traders exist if active investing does not make sense? What is their meaning, if it is much more profitable for any player to deposit money in SPY (S&P500)?

If everyone would be passive investing, who would give money to a newly created and promising company? For this company, there is no market value yet and so we cannot include it in those passive portfolios.

Wirecard is also a good example. It was a huge scam and at the same time in the portfolios of many. When journalists reveal the scam, someone needs to sell that stock so that it eventually is removed from so-called passive portfolios.

Those people taking the risks also get extra returns. The only question is whether they're just lucky or whether there exists some method to systematically have these profits.

yellowcake0
Hedge funds exist to manage risk. Suppose I offered you a choice of either a guaranteed 10 million dollars, or a 50% chance to win 20 million dollars, which would you choose? Probably option one, now suppose I slowly increase the dollar amount of option two, at what point would your choice flip to the second option? That point will not be the same for everyone, and its expected value minus 10 million is called the risk premium.

Because of the decreasing marginal utility of money, many wealthy people are interested in capital preservation, in other words, they're willing to underperform the market if it means a significant reduction in volatility. Hedge funds can provide this type of service.

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usgroup
> Warren Buffett argues that active investing doesn't make sense because it loses out to passive investing in the long run. I agree with this.

He is an active investor… He may argue for buy and hold the S&P for ordinary folks, but he’s obviously not advocating no one actively makes decisions about specific companies — that’s literally what he does.

b20000
why do we need facebook?
b20000
trading exists for price discovery. market participants decide on the fair price of something by willing to buy or sell at a certain price. in commodities this is how the price of milk, corn, etc is determined.
heroiccocoa
Another use I don't see mentioned yet is that they offer investors an uncorrelated source of returns from the main asset classes (stocks and bonds). According to Markowitz and modern portfolio theory, including such an asset in the portfolio will make it more efficient (better risk/return). Then, you can leverage the whole thing back up to the original level of risk and get higher returns. Also search for the modern re-branding of this concept known as "return stacking".