When hedge funds stop hedging they become just like every other pool of money looking for a hot return. That is, they cease positioning themselves to take advantage of mob sentiment and the errors of the masses. Instead, they begin to make the same errors themselves. Instead of profiting from crowd psychology, in other words, they have come to reflect it.
But are all hedge funds losers? Not at all. Some use very detailed, very smart methods to beat the crowd.
One of the original hedgers, for example, figured out that he could make a better guess about cocoa crop yields than most investors were getting. He studied the meteorological data…and sent his own agents out into the cocoa fields to gather data. The result – he had a better idea of how good the crop would be earlier than most other investors. His fund did well.
We know of another hedger who realized that the crowds do not respond very quickly to company ‘earning surprises.’ The new data eventually works its way into the price…but not immediately. Analysts need to study it. And then it is presented to investment committees. The whole process can take a few weeks…or months. So, this hedge fund merely reacts to earnings’ adjustments more quickly than the great mass of investors.
There are many other hedge funds that have found little niches like these to exploit. Result: better performance.