Mathematician Dr. Edward Thorp using his blackjack "system" to beat the house at the Tropicana casino in 1964.
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The critical issue is leverage. Hedge funds make trades that are meant to be low risk, but do so with huge sums of borrowed money, so the consequences are magnified when the bets get too risky or too wrong. The textbook case of this was the 1998 fall of heavily leveraged Long-Term Capital Management (LTCM), which briefly threatened to take the global financial system down with it. Nowadays, no single fund commands as much clout as LTCM did then, and the banks that loaned to it presumably learned something from the debacle. But the fund industry as a whole is much, much bigger.
Thorp, who at 74 no longer runs a hedge fund but still invests in a few, doesn't worry too much about a meltdown. "My opinion is that the most likely scenario is not a blowup but rather that hedge funds as a group will gradually and continuously lose their edge (if they haven't already) over other asset classes," he writes in an e-mail. "Then they will 'top out'--like mutual funds, real estate, etc.--and then just be a fluctuating fraction of total financial assets--part of the financial landscape."
Even this, the ice scenario, is bad news for the many pension funds that are only now plunging into hedge funds. Top hedge funds are often closed to new investors, meaning that newcomers are apt to get worse-than-mediocre performance while still paying 1% or 2% of assets and 20% of the profits to the managers. There is a cheaper alternative: just as Vanguard launched the first stock-index mutual fund in 1976, Wall Street firms are beginning to offer low-cost funds that mimic common hedge-fund strategies. The first get-together of this nascent "hedge-fund replication" industry is happening this month in London (official slogan: The clones have landed). Mediocrity doesn't have to be such a bad thing, as long as it's intentional.