So Much Money, So Much Talent — written as a counterpoint to the Wall Street Journal‘s “So Much Money, So Little Talent” — gives a decent overview of hedge funds:
To argue that hedge funds only made money as the result of a perfect storm of macroeconomic factors is to confuse the issue. It’s more accurate to say that hedge funds made money in volatile markets – and what markets are more volatile than those experiencing the spectacular deflation of a worldwide stock bubble? Most hedge funds are essentially market-neutral, hence the term ‘hedge’ fund. If the market goes up, they make money. If the market goes down, they make money. It’s only when the market meanders around without too much activity that hedge funds have a difficult time making money.With the hedge fund industry tripling in size over the past five years to become a trillion-dollar industry, it’s not surprising that so many hedge funds are racing into new, more illiquid financial instruments and exploiting more sophisticated trading strategies. If you believe in the Efficient Markets Hypothesis, this makes sense. Given efficient markets, it’s almost impossible to beat the market consistently. (Imagine thousands of MBAs running around, trying to find a market edge over their rivals.) Thus, these hedge fund investors are searching for market inefficiencies, in the hopes of exploiting improperly valued assets before others do. If close to 80% of mutual fund managers fail to out-perform the market, it’s safe to say that a similar percentage of hedge fund managers will fail to out-perform the market if they stick to vanilla trading strategies that ignore these types of market anomalies.