Provocative question for any manager - Who is taking the other side of the trade?

• Who is taking the other side of your trades? 
• And why are they willing to lose so that you can win? 

- from "Where’s the Beef?" by Rob Arnott, Amie Ko, Lillian Wu of Research Affiliates

These are interesting questions that should be asked of any hedge fund manager. Especially for short-term trading for every winner there has to a loser. The loser may just be asking for liquidity, the cost of the trade, but there is a penalty when a hedge fund wins. If the hedge fund says that he is smarter and that is his edge, then you must ask who is dumb. If the hedge fund says that he has an information edge, then you must ask why others do not have this information. If the hedge fund says that it processes information better, then you must ask why others cannot do this processing. For every reason given for an edge, there must be a reason why others do not or cannot have that edge. There edge can make good sense, but what are the restrictions on why others cannot do it?

The corollary to who is taking the other side of the trade is why are they willing to lose to you. The liquidity story makes sense, but it cannot be used in all cases. Is it ignorance that creates losers? Friedman would say that there is a limited number of losers, so markets will become efficient and move to equilibrium. Does there have to be an endless supply of losers for the winners to make their alpha? 

These are worthy questions that should be posed during any due diligence. Structural reasons are good. Liquidity is a good answer. Just saying that you are smarter than the average investor or hedge fund is harder to believe.