The Efficient Market Hypothesis (EMH) explained by Eugene Fama and tought on every university all over the world might have something valuable to tell us regarding hedgefunds: In 2003 the average hedgefund returned a measly 3% on average (according to Tremont Advisers). The average return have dropped to only 1% so far this year. Even "risk-free" US government bonds return more than this. At the same time almost 800 funds closed down business (but mainly small funds). This is a far cry from the "promised" double digit return with less risk than the traditional buy and hold strategy in stocks. How come the average return is so low? The large amounts pouring into hedgefunds are driving down the returns that attracted that money in the first place. To make things worse, most of the funds borrow wast sums of money to increase the returns. This means even more money running after the same opportunuties. This closes the window of opportunity. To make money, you have to make it from someone else.

The supply of hedgefunds has risen dramatically over the last years. Traders flock to set up hedgefunds because they can earn a lot: typically, funds charge a 1% management fee and 20% of profits. If you manage 100 million USD and make 5% profits, you have earned 2 million dollars. Not bad, because overhead is mainly manpower and some office space.

Is it a coincidence that average return plummets at the same time as they manage more money? I dont think so. In my opinion the falling return can partially be explained by the EMH. There are too much money chasing similar strategies. When everyone tries to achieve the same, there simply isnt enough to prey on. Hedgefunds mainly use market neutral strategies, for example pairs trading, or some kind of arbitrage. These "anomalies" can only exist when there are few players. The more players, the more difficult to prey (I have already written an article about this - the food chain in the stock market derived by Dr. Niederhoffer). For instance, according to The Economist there are an incredible 600 funds specialising solely in corporate bonds. To increase return you have to take on more risk. More risk often means more borrowing - closing the window of opportunity even more. 

Is there something to be learned here? Yes, if you have something going, by all means keep it to yourself. And the "boring" buy and hold strategy in stocks might be quite good after all.