Back in late September I was surprised to learn that SAC Capital, one of the largest hedge funds in the world managed by Steven Cohen, decided to pull the plug on their vast $16 billion dollar hedge funds.

In hindsight, this was a smart move by Cohen because his trading models apparently became dysfunctional following the collapse of Lehman Brothers Holdings.

Approximately two-thirds of all hedge funds trade credit markets. Most investors think hedge funds overwhelm equity market trading, and, to an extent, that’s true; but the bigger boys play in credit.

When your trading models cease functioning, the right thing to do is to stop trading, raise cash and wait out the storm. That’s what SAC Capital did. But the majority of hedge funds, overwhelmed by the massive demand from investors to redeem, instead chose to freeze redemptions, which logically compromised their portfolios because of forced sales. That’s especially the case when your assets are partially illiquid. It’s a snowball gathering momentum in the Alps; the outcome is horrid.

In addition to investing in distressed debt and other segments of fixed-income, including leveraged loans, asset-backed lending and convertible bond arbitrage, these managers used to employ up to 10 times leverage or more. All of this is now unwinding over the last few months as losses hit all-time highs for hedge funds in 2008 – the worst year on record. Latest estimates point to a 25% loss for the median hedge fund this year compared to -40% for the S&P 500 Index and -45% for the MSCI World Index. Already more than 15% of all hedge funds have closed or failed.

For hedge funds, the party started to fade in July when commodities began to implode. Worse, Lehman’s failure in mid-September accelerated the crash in credit markets resulting in formidable losses for many hedge funds in September and October. November was no different.

I’m still a fan of hedge fund investing. Still, I’ve tempered my enthusiasm for this asset class compared to ten or fifteen years ago. My favorite hedge funds are those specializing in bankruptcy reorganization, distressed debt and asset-backed lending – sectors of the market that require acute credit risk analysis that’s way above my head. These managers deserve to be paid the big bucks if they can make money collateralizing loans and assets and figuring out exactly what some of these companies are really worth.

What really irks me is the long/short hedge fund sector disguising themselves as “hedge” funds in the first place. In reality, most long/short hedge funds don’t know how to hedge properly and fail to beat the market – still charging you 20% of profits. Shorting stocks is an art; most managers just don’t know what they’re doing.

Not all hedge funds bled this year. Some global macro hedge funds made a killing in 2008 while managed futures gained big profits riding trend-following trading models. These guys were net short equities, long bonds, short commodities and long the dollar since July or August.

The rest of the hedge fund industry is now living on borrowed time. This nonsense of locking-up investor capital for 5 years, charging a 20% incentive fee for generally failing to beat the market and providing poor transparency is over. Redemptions continue to flood the industry this fall and, ahead of December 31 – a major liquidation date for investors, more hedge funds are now forced to sell securities to raise cash. It’s ballgame over for most managers.

It was a nice party while it lasted.