09/12/2007 11:38 pm ET Updated May 25, 2011

Know When to Hold 'em...

The term "hedge fund" has been a misnomer for awhile, given that many hedge funds follow very different strategies than the classic long-short approach that gave the funds their name. But now we know that the term is inadequate for a different reason -- that many of those long-short funds designed to actually "hedge" have been as successful at "hedging" their bets as Bush has been at "accomplishing" missions.

The original hedge fund was designed by Alfred Winslow Jones in 1949. It was created to literally "hedge," that is, to short some stocks while buying others; this strategy was intended to protect against downturns in the market by shorting stocks deemed overvalued. The theory was that in a market break, the shorts would rise in value and thus limit the downside.

Over time, this strategy morphed into varieties like market-neutral, macro and stat-arbitrage, and merger-arbitrage, all designed to make money regardless of market conditions. With the proliferation of highly regulated mutual funds, the term hedge fund today only means a fund that is not registered under the Investment Company Act--and can thus do things the former cannot, such as leverage itself, concentrate positions, or buy illiquid securities. Most are trading funds, speculating on price discrepancies with tweaks on the long-short model, while others (like the one run by my firm) are investment funds, investing in companies for the long haul, identifying special values or catalysts to drive returns. These investment funds do not often have short positions at all. They are not designed to be market-neutral, only to make money over time, often at the expense of short-term returns. They're not sexy and they do not make many headlines.

The trading funds have had some high-profile losses reported of late. It's always impossible to know exactly what's going on inside such funds, but according to Reuters, a partial list reads as follows: the Bear Stearns Funds (down more than 90%), Sowood Capital (down roughly 50%), Tykhe Portfolio Ltd. Class C (down 26.5%), Basis Capital (down around 80%), the Maquarie Bank Funds (down about 25%), Basis Capital Alpha Fund (filed for bankruptcy). Many funds, such as Pirate, Sentinel and Y2K Finance have reportedly had to "freeze redemptions," which is a polite way of saying you can't have your money back (perhaps because the assets in which we're invested are worthless at the moment). Buried in this spectacular news is the more mundane way in which trading funds have fumbled. According to Bloomberg, many have supposedly suffered more middling summer losses, leaving their investors unprotected from the downdraft in the overall market. For example: one of Moore Capital's Funds (down around 9.5%) and the Hermitage Fund (down 11.8%).

These declines are not surprising. Despite the proliferation of different strategies, hedge funds within the same grouping often pursue similar trades. As more and more money flows their way, the opportunity for excess returns shrinks. In this sense, these losses are the start of the bursting of the massive hedge fund bubble. Those who doubt the dangerous nature of a trading strategy just have to consider the following: Trading is a zero-sum game in that for every winner there must be a loser. In other words, when a trader shorts a share of Google, he is borrowing it from an owner who must be paid back eventually. And only one of them--the trader or the owner--can be right in that transaction: the stock will either go up or down. The odds are actually worse than 50/50 since the "house" (in the form of borrowing costs and commissions--Wall Street's version of double-zero on the roulette wheel) makes no trader's random chances better than 49%.

In contrast, two investors can both buy Citigroup and hold it for the long-term, confident that they both will make money if the corporate profits rise over time and the valuation is reasonable. This is known in not-so-formal economic terms as an ever-expanding pie, and it's the secret recipe of the most successful investor, Warren Buffett.

The disadvantage of investment is that it requires patience and so is totally unsuited to gamblers. It is also useless to those who wish to get rich at another's expense, since it's only as a trader that you trade "against" someone and thereby dine on caviar while they're scavenging the trash bin.

The talented speculator Jesse Livermore, who amassed an enormous sum by shorting the market in 1929, and built and lost his fortune many times, at the end knew his flaws too well. Today, he probably would have been a hedge fund manager. After years of exchanging estates in Great Neck for fleabags on the Bowery; after numerous bankruptcy filings followed by big comebacks; after buying the best diamonds at Harry Winston and then pawning them on the heels of the inevitable "missed" trade, he realized that a gambler lives to lose as much as to win. And he put a bullet in his head upon the realization.

I've heard whispers that many hedge funds are not valuing their illiquid securities properly and, therefore, the value they report to investors may not even be accurate. I've also heard that many are desperately trying to make up losses, leveraging themselves to the hilt in the style of Long Term Capital Management (the fund that lost its designer shirt in 1998). If true, this all bodes poorly for future returns. Trading returns will continue to get arbtiraged away by too much money chasing too few trades. Blow-ups will continue to ravage the disaster du jour. All the while, investors in trading funds never really even know how those funds are doing, and never know what securities they hold since those holdings change second-to-second. On top of it, they never know when a trading fund will say "we're not giving your money back." This sounds like an awful way to live.

The investor, as opposed to the trader, will never feel especially omnipotent; nor is the investor likely to go broke. All of which is probably good for those who would rather make that all-important lifetime trade: exchanging gambling for a little common sense.

As the old Kenny Rogers song goes, "you gotta know when to hold 'em, know when to fold 'em, know when to walk away, know when to run." Traders, more than anyone else, know the tune.