Many hedge funds fail for many different reasons, but we will now look at two of the more famous cases and investigate why they failed.

Bernie Madoff defrauded his hedge fund investors of 65 billion US dollars in what was effectively a Ponzi scheme run across multiple funds.

A Ponzi scheme is a form of fraud that pays profits to earlier investors with funds from more recent investors. It can also be called pyramid selling. The scheme leads victims to believe that profits are coming from legitimate business activity, and they remain unaware that other investors are being used as a source of funds. As the scheme achieves larger scale, it ultimately cannot attract new funds fast enough to sustain its continued growth. Finally, the scheme crashes causing harm to later stage investors, whilst vast monies accrue to earlier investors, as well as the founders or fraudsters.

Key lessons from the Madoff funds collapse with hindsight include one, beware bond-like volatility with equity-like return. As can be seen from this diagram, the performance of the Madoff funds was in line with the S&P 500 and the SSC hedge fund over the long term. This diagram covers the period from 1990 to 2008, but with hardly any volatility at all. This is what led some analysts to believe that his returns were too good to be true. Two, secretive firms are often secretive for a reason. There are a number of external advisors, such as custodians and auditors who are meant to act in the interests of clients of a fund to make sure this type of thing doesn't happen. Sometimes these advisors don't do their jobs. The auditors and custodians of the Madoff funds were not the larger globally renowned accounting firms and banks, but rather smaller local firms over whom Madoff could apply his influence. Three regulators are often financial archeologists looking at things that have gone wrong historically rather than investing current more pressing issues.

Another good example of hedge funds going wrong is LTCM. Long-Term Capital Management or LTCM was a hedge fund founded by a number of renowned academics, including Myron Scholes, who helped develop the Black–Scholes Merton option pricing Model. LTCM had, as can be seen significantly outperformed the s and p 500 from March, 1994 to March, 1998, and that its peak had over $127 billion of assets under management. LTCM followed an arbitrage strategy Profiting from mispricing of similar securities in different markets. However, since pricing differences can be small in percentage terms, LTCM used significant amounts of leverage to generate strong absolute returns for their investors. However, LTCMs investments began losing value after the 1998 Russian financial crisis. Such were the size of their losses totaling over 3.5 billion. At one stage, the Federal Reserve stepped in to organize a bailout fund funded by 14 leading investment banks to stop LTCM collapsing. The Federal Reserve's intervention in LTCMs collapse brings up questions about regulators and government's roles in protecting private financial institutions.

So why did those leading investment banks bail out? LTCM, LTCM was deemed too big to fail, and at the time posed a systematic risk to the wider US and global economies.

There was a risk that if LTCM defaulted on derivative contracts and loans, then other financial institutions who were owed money by LTCM would then suffer significant losses themselves and risk bankruptcy. The leading investment banks were pressured, literally locked in a room together by senior politicians and regulators to structure a syndicated bailout plan for the benefit of the market as a whole.