The coming hedge fund meltdown

At first, hedge funds were truly innovative. Eventually, though, so many new funds poured into the industry that they eroded the competitive advantage of the original investors.

Hedge funds, it turns out, were not "hedged" in any meaningful sense of the word. Too few shorted enough stock or managed risk prudently.

Recent months have made it clear that hedge funds as an industry were, as the wisecrack had it, a pay scheme masquerading as an asset class.

Sure, many funds have their "high-water marks," meaning they don't receive their performance fees until they get back to peak levels. But many won't bother staying in business.

• Talk back: Who’s to blame for the financial crisis?

Some managers may harbor secret hopes of reopening with new funds, à la the patron saint of undeserved second chances, John Meriwether, who blew up Long-Term Capital Management before blowing up it again this year. But this time, the world won't be fooled again. At least we hope.

To be clear: Though no group benefited more from the worldwide speculative bubble -- not corporate chieftains, not homeowners, not individual investors -- hedge funds didn't cause the credit crisis. Some are doing well, even spectacularly. And many will survive.

While hedge funds have been attacked for their risky behavior, in the end they weren't the causes of systemic collapse. It was the "respectable" outfits -- Bear Stearns, Lehman, American International Group (AIG, news, msgs), Wachovia (WB, news, msgs), Washington Mutual -- that went down, bringing the world's financial system with them. Hedge funds are now feeling the aftershocks.

Which is perhaps how it should be. The truth that's now becoming clear is that hedge fund managers didn't have some magical ability to spin wealth while the rest of us toiled at our day jobs. Instead, they made money because markets were predictable, stable and, for the most part, up.

Hedge fund managers reached their apotheosis in recent years because of their dazzling performance after the Nasdaq crash. They seemed to have made good on their promise to make money in friendly markets and bad ones. But that was easy. Other than tech stocks and giant blue chips, nearly every possible asset class and sector had become cheap by 2000.

Stock hedge funds shorted the obvious garbage and bought the cheap stuff, like real estate and industrials. Over the next several years, the investing world was placid. Prices didn't gyrate. With interest rates low, it was logical to make more risky investments.

That led to a worldwide bubble. Too much money was chasing the same things.

Continued: Self-inflicted problems

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