I'm quite surprised that you were (I'm already assuming you'll change positions) leaning toward the position that "excess payouts to early investors is central to the fraud perpetrated by such hedge funds, so the gains were never real in the first place, and therefore they should be paid back." Unless there is evidence that the selling investor knew of the FRAUD (not that they knew these were bad guys or that the office had no furniture or that the managers all owned multiple helicopters), then the early exiter shouldn't be held responsible. Let's look at the first part of the quote: "excess payouts to early investors is central to the fraud perpetrated by such hedge funds . . . ." What does this really mean? All this says is that an innocent investor sold at a point that made sense from an investing standpoint, according to the information available, some of which was incorrect (namely the actual gains). This might have been dumb luck or, as Going Private so articulately describes (http://equityprivate.typepad.com/ep/2006/08/beware_dark_fig.html), through good due diligence. As for the statement about "the gains were never real in the first place, and therefore they should be paid back." True, the gains were not real, but the receipt of funds based upon what was represented as true (the fund's account statements to investors) is not fraudulent, as the comments suggest.

Paul, by your logic, anyone who made a dime in Enron within five years of its demise did so improperly, and should return these "illgotten" gains to buyer of their stock. This is obivously an impractical resolution and, in my mind, an intutively unsound one.

This seems to be a clear example of where "Caveat Emptor" is a good thing. Think about the downstream effects of the two alternating approaches:

1) If the name of the game is Caveat Emptor, then potential investors in hedge funds will have that much more impetus to do their own due diligence, and take responsibility for their own investments.

2) On the other hand, penalizing early investors for later discovered fraud opens a Pandora's box for the lawyers, invites more stupid legislation, casts a shadow of political risk on investments in legitimate, non-fraudulent hedge funds, and mollycoddles investors in general, giving them the false assumption that Uncle Sam will take care of them if they fall for a scheme.

The further ironic thing is that a Caveat Emptor might lead to better fraud dection methodologies in the first place, as private market solutions would no doubt spring up to help meet wary investor demand.

The crybabies shouldn't get a nickel.

Okay, I feel suitably scolded. I guess I'm so suspicious of audited hedge fund performance results, hedge funds with "happy" investors who are actually insiders, and so on, that I was looking, wrongly, for something better than caveat emptor.

As people point out, however, this leads to some deeply soft and problematic stuff, so however bad it might be, we'd be worse off if latter investors could sue money back from earlier investors. You'd never know your real liability from a hedge fund investment.