A friend who is a securities lawyer writes:
I wanted to respond to your post and Jim Manzi's about the burgeoning "hedge funds are nothing more than a giant odds-playing scam" meme. Regardless of your views on the EMH, that meme is completely ignorant of the way the legal and market regimes governing hedge funds actually work. Maybe their investment ideas don't work as well as they'd like, but (a) investors generally know what the funds' investment strategies are, and (b) they think they work. Maybe delusions, but few scams.
So, your friend works for a firm with hedge fund clients. And I would expect a Milberg LLP securities lawyer (or a certain former-NY AG) to say the exact opposite. Of course, the reality is closer to your friends view in almost all cases (and undoubtedly for all of his/her firm's clients), but the blanket statement simply isn't true.
And "investors generally know what the funds' investment strategies are" is rather imprecise; it's more like "investors [should be expected to] know what the funds' investment strategies generally are".
Y'all need to check this brilliant piece for the full story:
http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1
where the only missing piece is an understanding of "mark to market" accounting and how it exaggerates swings. You can get that here:
http://s.wsj.net/public/resources/documents/WSJ_oaktreememo0803.pdf
and this one:
http://online.wsj.com/article/SB120468197325912303.html?mod=relevancy
this last one may require subscription to WSJ. It's from 5 March, 2008, entitled "Is fair-value accounting always fair?", by David Reilly.
Then ponder what you think the yahoos on the Hill understand of all this. And be afraid, very afraid.
Here's the way to make money:
Take gains from success, but give risks to others. In real estate one can do the Trump method... form some kind of limited liability firm for a project. Using as little of your own money as possible, borrow millions from banks with that firm to . If the project is a success, profit and write a book. If the project fails, have the firm declare bankruptcy, let the bankers recoup pennies on the dollar and move to the next project.
For JP Morgan... realize Bear's assets are worth more than the stock price, get the Fed to take responsibility for its liabilities... profit.
I used to invest in a few hedge funds. I realized the same thing that you're posting about a few years ago.
That said, I don't think they're a scam. Most of the people who work at them don't really understand how they're playing with risk. They are deluded (which is easy when you make so much money from having an incorrect model of the world), not scammers.
Still, the sooner that more LPs understand what's going on, the sooner they'll stop investing. So, it's a good thing to explain to people...
You're first impression is correct. Most hedge fund investors have no idea about the strategies hedge funds employ. Quite a few hedge fund managers manage several funds that take bets opposite each other. Fund A bets on an industry/stock/market going up, Fund B bets on the same going down. Usually, one wins and one loses. The losing fund gets wrapped up at the end of a certain period -- sorry, investors, but we are closing this fund because of poor performance, but thank you very much for your fees. The other fund remains and, miraculously, has an amazing performance. In fact, since that's the only remaining fund, when new investors ask about the manager's performance, guess which data is provided? (Because, after all, there are no government disclosure requirements for hedge funds...) The best way to make money on a hedge fund is to manage one. In most other cases, you'd do better with a cheap index fund.
Do you have specific examples of this? There aren't all that many institutional buyers, compared to the retail market, and a manager's reputation is all he has, so I'm skeptical that this is common.
There are no form requirements, but there are certainly disclosure requirements. You may be familiar with this one: