By your first point, hedge funds are the market, and so between all of them, ought to average exactly the market returns. By your second point, they measure their returns against the market, and so on average should return 0%.
Why should anyone ever invest in hedge funds, under these premises?
A much simpler (and probably truer) explanation is "What goes up, must come down." Hedge funds booked large paper profits during the boom; now it's time for them to book large paper losses in the bust. Except that if their customers get scared, those large paper losses turn into large actual losses.
Ah, but you missed the "other things being equal" part. ;) If the markets move as a whole and hedge funds are heavily long on the market, but others are market-neutral, or even short, things are not equal.
Right, but on the whole, you'd expect those all to average out. If the markets move up and hedge funds are long, they're as likely to move down while hedge funds are long, or move up while hedge funds are short.
That is why better hedge funds know when to be long and when to be short. My explanation makes a lot of assumptions for simplification, because it is impossible to know what every hedge fund is doing at every point in time.
By your first point, hedge funds are the market, and so between all of them, ought to average exactly the market returns. By your second point, they measure their returns against the market, and so on average should return 0%.
Why should anyone ever invest in hedge funds, under these premises?
A much simpler (and probably truer) explanation is "What goes up, must come down." Hedge funds booked large paper profits during the boom; now it's time for them to book large paper losses in the bust. Except that if their customers get scared, those large paper losses turn into large actual losses.