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The few hedge funds that I am familiar with do not engage in day trading. One of them makes equipment lease loans at very high rates with the capital item as security (they get rates in excess of 18% plus a 3% origination fee, a very good business). Another one invests in deeply distressed companies. And another one has been buying heavily discounted mortgage paper. Talk about high risk!

Most of the heavy volume on the markets comes from hedge fund momentum traders. I agree that isn't the only strategy hedge funds use, nor is derivatives. The problem is, with no oversight, legitimate high risk strategies cannot be differentiated from momentum trading and cheating.

It is possible to do the legitimate high risk/high return approach on the secondary market. On the average junk bonds have historically paid more even accounting for defaults than investment grade bonds. But to get returns hedge funds need to get to cover the expenses, not to mention to satisfy their clientele, takes a lot more than just normal junk. That's where things like distressed companies and sub-prime mortgages. Making direct loans at high rates is an example of direct high risk/high return investing.

There would be nothing in an open-books hedge fund industry to prevent legitimate high risk investing—the kind of stuff you are describing. But I don't think that kind of investing is going to provide enough opportunitiess for most hedge fund money. Legitimately providing capital to those, such as start-ups or people who are stretching to buy a house, is good economics, and it is appropriate that those who risk capital for these purposes be rewarded. But when investing in start-ups turns into a sure thing thanks to investment banking pump and dump scams (as c. 2000) or when sub-prime is government-backed, then the risk part disappears. And I don't believe momentum trading and derivatives has anything to do with this kind of risk taking. So if the hedge funds doing this are going to make enough to justify their existence, they are either playing zero sum with other hedge funds, or they have found ways to take money from investors who are not playing the game, for which we have seen evidence (and there is a lot of suspicion of collusion, especially with small caps, where hedge funds can probably work together to force momentum, circumventing rules that prevent large mutual funds from doing so).
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