Hedge Funds Are for Suckers … At the height of the financial crisis in 2008, a group of famous hedge fund managers was made to stand before Congress like thieves in a stockade and defend their existence to an angry public. The gilded five included George Soros, co-founder of the Quantum Fund; James Simons of Renaissance Technologies; John Paulson of Paulson & Co.; Philip Falcone of Harbinger Capital; and Kenneth Griffin of Citadel. Each man had made hundreds of millions, or billions, of dollars in the preceding years through his own form of glorified gambling, and in some cases, the investors who had poured money into their hedge funds had done OK, too. They were brought to Washington to stand up for their industry and their paychecks, and to address the question of whether their business should be more tightly regulated. They all refused to apologize for their success. – BusinessWeek

Dominant Social Theme: Once again, the private sector doesn't deliver.

Free-Market Analysis: There is a sort of gloating quality to this article that is not usually seen in BusinessWeek. But perhaps that is because hedge funds have come to represent free-market capitalism and are therefore fair game for criticism by the mainstream media, which tends to be statist in its outlook and criticisms.

Of course, to be fair, hedge funds deal with modern capitalism as it is and the phenomenal amounts of money they make are the result not of hedge fund mechanisms but the larger evolution of the securities industry.

One can trace back securities-industry centralization to a post-Civil War effort at consolidation. The New York Stock Exchange went on a buying spree and merged with a dozen or more New York exchanges. JP Morgan began his industrial rise to a point where his companies would apparently be responsible for vast swaths of the US GDP.

On it went. Perhaps the most significant consolidation occurred after the 1930s Pecora hearings that established the beginning of the modern regulatory state. The Securities and Exchange Commission, the NASD and various self-regulatory organizations (exchanges) enshrined the status quo and made its diminishment difficult.

A few were empowered by regulation and custom to preside over vast money pools. At first, this handful of individuals and firms did so within an approved regulatory context. But after a while, private players appeared who took advantage of the enormous – and rigid – superstructure in ways that were more personal and less corporate.

Of course, the system had never REALLY been corporate, only made to look that way. Nevertheless, those who created the system were not happy that it was being hijacked by outsiders who benefited from the immense centralization of order flow while avoiding regulatory strictures designed to shut out the hoi polloi.

Such resentment can certainly be sensed in this BusinessWeek article. Here's more:

They appeared untouchable. What's happened since then is instructive. Soros, considered by some to be one of the greatest investors in history, announced in 2011 that he was returning most of his investors' money and converting his fund into a family office.

Simons, a former mathematician and code cracker for the National Security Agency, retired from managing his funds in 2010. After several spectacular years, Paulson saw performance at his largest funds plummet, while Falcone reached a tentative settlement in May with the U.S. Securities and Exchange Commission over claims that he'd borrowed money from his fund to pay his taxes, barring him from the industry for two years.

Griffin recently scaled back his ambition of turning his firm into the next Goldman Sachs (GS) after his funds struggled to recover from huge losses in 2008. As a symbol of the state of the hedge fund industry, the humbling of these financial gods couldn't be more apt. Hedge funds may have gotten too big for their yachts, for their market, and for their own possibilities for success.

After a decade as rock stars, hedge fund managers seem to be fading just as quickly as musicians do. Each day brings disappointing headlines about the returns generated by formerly highflying funds, from Paulson, whose Advantage Plus fund is up 3.4 percent this year, after losing 19 percent in 2012 and 51 percent in 2011, to Bridgewater Associates, the largest in the world.

This reversal of fortunes comes at a time when one of the most successful traders of his time, Steven Cohen, founder of the $15 billion hedge fund firm SAC Capital Advisors, is at the center of a government investigation into insider trading.

Two SAC portfolio managers, one current and one former, face criminal trials in November, and further charges from the Department of Justice and the SEC could come at any moment. The Federal Bureau of Investigation continues to probe the company, and the government is weighing criminal and civil actions against SAC and Cohen.

Cohen has not been charged and denies any wrongdoing, but the industry is on high alert for the possible downfall of one of its towering figures. Despite all the speculation and the loss of billions in investor capital, Cohen's flagship hedge fund managed to be the most profitable in the world in 2012, making $789.5 million in the first 10 months of the year, according to Bloomberg Markets. His competitors haven't fared as well.

One thing hedge funds are supposed to do—generate "alpha," a macho term for risk-adjusted returns that surpass the overall market because of the skill of the investor—is slipping further out of reach. According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor's 500-stock index by approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their brilliance.

… For investors who chased the colossal returns once promised, the downturn may well bring painful losses. But it could also be the beginning of a virtuous cycle. If it's going to survive, the industry may need to get smaller and a lot more modest.

One can almost hear a relieved sigh behind this last point. The buccaneering class is getting what it deserves. The old order is to be reestablished and regulatory democracy will assume the kind of primacy it enjoyed in the mid-20th century.

This is a kind of pipe dream, from our point of view. Technology and the Internet have virtually exploded the old model and the best thing that could happen would be for the centralization of the securities industry to give way to fragmentation.

Just as big banks are artificial judicial and regulatory constructs, so is the securities industry. The SEC just made some minor steps toward deregulation but this may only be a harbinger of what is yet to come. While many argue the merits of additional regulation, decentralization proceeds apace, with its own logic.

BusinessWeek reporters can sneer at the enormous profits of hedge funds and the crassness of their leaders but the solution to "pirate capitalism" is less regulation not more.