However, I don’t see why it takes much sophistication to hand over a fat cheque to a hedge fund manager. Combine that with the fact that hedge funds as a whole don’t seem to outperform the market generally, I don’t think that hedge funds deserve their reputation.
From what I learned about a few different hedge funds, here is my own (possibly flawed) view of the typical hedge fund:
1. Some very clever guy develops a trading strategy with a good chance of outperforming the market and a small chance of going bust.
2. This clever guy doesn’t want to risk his own money because of the possibility of going bust.
3. He has the bright idea to start a hedge fund to use his strategy and collect fat performance fees if the fund does well.
The great thing about this approach is that the hedge fund manager doesn’t lose any of his own money if the fund goes bust. The manager takes a big slice of the upside and leaves all of the downside for the
This model works well for the manager even if the fund’s expected return taking into account all possibilities is less than the market’s expected return. Even if the fund blows up after a few years, the manager will get his fees up to that point.
No doubt this isn’t a fair characterization of all hedge funds, but I certainly wouldn’t invest in a hedge fund until I was fully satisfied that it didn’t match this general description.