> Their fee structure incentivizes volatility, not long term performance

Can you explain why?

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.

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.

Most of the arguments in this comments sections are outdated.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.

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.

Quite right, though the high water mark approach predates 2008.

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.

The article is wrong. See the other comment about High Water Mark. Long-term the fund only takes the profit on the total return.

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.

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).

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.

> you can't just close it and open again

Actually, you can if you declare bankruptcy.

You just pick up the factory, set it up in a different part of the world, and start it up again?

You don't even have to move it. You can set up a pre-pack insolvency, then buy up the business - assets, employees, stock, everything - in a new company and just keep going, but without the debt. There have been some scandals about business owners doing this, but I don't think it's been entirely effectively stopped.

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.

How is this a harm to the market? There's nothing inherently bad about volatility.

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.