2013 has been a horrible year for hedge funds

The stock market may have rocketed ahead this year, but hedge fund managers, by and large, have been left behind. As Bloomberg reported last week: "The $2.5 trillion hedge-fund industry, whose money managers are among the finance world's highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005."

Bloomberg's aggregate hedge fund index trailed the S&P 500's return by 22 percentage points through November, making the industry a lock to trail the broader market for the fifth year running.

If that wasn't bad enough, 2013 is likely to go down as the personal annus horribilis for some of the most prominent names in the business — folks whom investment bankers and traders slavishly fawned over, and whom were once able to move the markets simply by hinting at what they were doing.

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Steve Cohen may be Exhibit A in this lineup. Back in 2004, when he paid an estimated $8 million for a moulting shark in a tank — an art work created by Damian Hirst that Cohen bought from modern art maven Charles Saatchi for what may have been 100 times Saatchi's cost — Cohen himself was top shark on Wall Street. Powering through the markets, he opened his jaws wide to snap up profits from his trades and fees from his investors, who were happy to pay him up to half of their gains.

Last month, SAC agreed to fork over a far heftier sum — a record $1.8 billion — to regulators to settle a series of securities fraud charges that arose from the SEC's probe into insider trading among the hedge fund elite. That's the culmination of Cohen's fall from grace. The man whose odd combination of reclusiveness and conspicuous consumption became famous on Wall Street now will be investing his own money, and perhaps that of a few friends who have stuck with him, but won't be controlling nearly as much of the market's daily trading activity as he once did.

More recently, we've seen reports that Eddie Lampert has had to cut his stake in Sears Holdings to try and meet the demand for redemptions on the part of his investors. Sears remains a top ESL holding, but Lampert has had to reduce his ownership stake in the company to 48 percent, down from 55 percent previously.

Lampert's 2005 deal to acquire Sears, Roebuck & Co. and merge it with his Kmart Holding Corp. was the transaction that made the fund manager something of a household name. But the merger has been a disaster. Yes, retailing has been a difficult place, but in the last few years, even former laggards like Gap (NYSE: GPS) and Best Buy (NYSE: BBY) have managed to execute turnarounds. Big box rivals like Target and Walmart may struggle with the tradeoff between their customers' insistence on low prices and investor demands for higher profit margins, but they aren't in the doldrums to the same extent as Sears, which is on track to deliver three years of declining sales and losses.

The fact that Lampert is having to cut back his holdings in companies like Sears and AutoNation in order to return money to his own discontented investors is a big warning sign. Hedge fund runs are just like bank runs: The sight of a hedge fund manager scrambling to cover redemptions is akin to driving past a branch of your own bank and spotting a long line of depositors anxious to withdraw all their cash. Even if you're convinced the bank is sound, anxiety ensures that you're likely to pull over and join the back of that line because you don't want to be the last fool, the guy who has been left to turn out the lights. The same is true at hedge funds.

Lampert may have made a big mistake in assuming he knew how to orchestrate a retail industry turnaround, but he may still be capable of running a hedge fund or private equity fund and doing very well for his investors. Perhaps. The odds are, though, that with every week that passes and every additional million dollars of redemptions, he's not going to get that chance. He has already relinquished majority control of Sears; now, Lampert is fighting to retain the remainder of his investment business. The odds don't necessarily favor him succeeding, even though it may be a loss of confidence on the part of his investors that doom ESL.

Then there's Bill Ackman, another hedge fund manager who found grief in the retail industry. The founder of Pershing Square Capital Management finally threw in the towel on his battle to revive JC Penney in August. After a futile 18-month struggle, Ackman liquidated his entire stake in the business and took a $700 million loss for investors. That's on top of a $500 million loss (so far) on Herbalife. Indeed, his most recent and most stubborn pronouncement of his conviction with respect to Herbalife just seemed to drive the stock higher.

Hedge funds have never been either well understood or popular, even when they've proved lucrative. But this year has seen public opprobrium hit new heights, with BusinessWeek taking official notice of the fact that the high fees hedge funds charge aren't always matched by high returns. "Hedge funds are for suckers," the magazine declared.

Well, yes — clearly. And no. Look at the three managers I've discussed above — Ackman, Cohen and Lampert — and you'll find three common elements: A very high profile, an outsize fund (and thus an outsize impact on the market), and a toxic combination of hubris and sheer bloody-mindedness. None of these are recipes for success on the part of any kind of manager, regardless of his or her investment strategy, prowess, or track record.

Ultimately, however, the lesson we draw from watching hedge fund managers implode or be taken out by regulators shouldn't be that hedge funds, by definition, are toxic investments. Rather, they're a bit like derivatives, those securities that Warren Buffett once famously referred to as "weapons of mass financial destruction."

Like derivatives, a hedge fund is only as dangerous to its investors or to the markets as the way it is used. A hedge fund of the right size, run by a manager who hasn't let his ego run away with him, who manages his portfolio and his risks with an eye to prudence and not just to maximizing his fees, can be a great idea for both markets and certain investors.

The fate of Long-Term Capital Management some 15 years ago should have reminded us that when it comes to hedge funds, problems materialize when managers start viewing themselves as infallible godlike creatures. Pride cometh before a fall, and all that.

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