"I worked at a hedge fund for two years before I knew what one was, jokes one fund employee, who, like many others in the secretive world of hedge-fund management, would talk to New York only if his name wasnt mentioned. Hedge funds are the sporty investment vehicles of the late nineties, but most people dont have a clue what they are. Maybe thats because theyre better defined by what they are not. A hedge fund comprises a group of individuals whose pooled money is invested by a manager. But unlike mutual funds, hedge funds arent SEC-regulated, and their managers dont have to be registered investment advisers. And if you arent an accredited investor -- that is, someone who makes at least $200,000 a year and has more than $1 million in assets (primary residence included) -- you can forget about parking your stash in one. Wealthy families, school endowments, and pension plans are among the largest investors in hedge funds. Think of them as mutual funds for the plutocrats; if you have to ask the price of admission -- well, you know the rest.
Hedge funds are very private, very lucrative, and very hot. It took just seven months to raise $1 billion for Ocelot, Julian Robertsons latest hedge fund at Tiger Management (on average, all of Tigers funds were up 63 percent through mid-December, before fees were subtracted). Robertson and George Soros are the industrys glamorous Garbos -- rarely talking to the press about their wheeling and dealing but still the subjects of endless fascination. Whenever the Wall Street Journal gets wind of their shopping sprees, the pairs purchases are dutifully recorded (see page 26 of this issue for their biggest recent buys). Generating considerably more ink is James Cramer, hedge-fund manager of the Cramer Capital Corporation, contract writer at Time and GQ, part owner of industry website TheStreet.com, and former New York Magazine financial columnist. Recently, Cramer joined the likes of Michael Jordan and Shaquille ONeal, appearing in footwear ads -- for Rockports, not Reeboks, but you get the idea.
Their often astonishing returns are splattered across the newspapers, so the names of these cowboys are on a lot of peoples lips -- even if the funds they run are banned from advertising. Not that the better ones have to. Just as at the Union Club, if you want to join in the fun, you have to know the right people. Some of these guys have waiting lists for investors, says John Broadhurst, a San Francisco lawyer who works with hedge funds. Casually mentioning your hedge-fund manager at a dinner party now has the cachet that owning an outsize house on Southamptons Gin Lane had in the eighties.
There is a growing feeling that the real money has tunneled into hedge funds -- where the managers (who usually invest their own money alongside their clients) get a 1 to 3 percent management fee in addition to 10 to 25 percent of the profits. The management fees ensure they make money anyway, even when their strategies dont pan out. The million-dollar bonuses paid to Wall Street investment-banking honchos look like a pile of peanuts next to the hundreds of millions hedge-fund managers and their relatively junior employees take home. Some of them have so much cash, theyve taken to giving it away: The legendary George Soros has disbursed more than $1.5 billion over the past twenty years (the bulk of it in the nineties) to all manner of causes. Soross right-hand man, Stanley Druckenmiller, and Tiger Managements Julian Robertson are two of five fund managers who preside over the philanthropic Robin Hood Foundation.
The perception is that many managers feel compelled to try to hit the ball out of the park to justify their immense paychecks. Hedge funds can carry a great deal more risk than a plain-Jane mutual fund. But stupendous risk sometimes yields stupendous rewards, as anyone who has invested with George Soros will tell you. Soross flagship Quantum fund has returned, on average, around 33 percent annually -- after fees -- since 1969.
A hedge-fund manager tries to make money any way he or she can: by going short or long on securities and by using currencies, options, futures, leverage, or any variety of white-knuckle (entirely legal) techniques to swell the coffers. Thats another reason managers tend not to welcome the scrutiny of the press. The hedge fund rubric is generally used to describe a fund that can invest in more than one asset class (stocks, futures, or currencies, for example); use borrowed money, or leverage, to increase investment assets; and hedge, which is simultaneously buying one security and shorting another, ultimately balancing trades to limit downside risk. While a mutual-fund manager is obliged to lay out a specific investment style in a prospectus -- and stick to it (or risk hearing about it from the SEC) -- a hedge-fund manager is free to employ whatever strategy he or she believes makes the most sense for different markets and investment conditions. Even with such a liberal charter, many hedge-fund managers have taken it upon themselves to outline their strategy for investors in a placement memorandum: some purposely give themselves tremendous flexibility; others set limits on their own investing activities.
Although mutual funds could have some of the same flexibility (as long as its clearly defined in their prospectuses), relatively few managers choose that route. There is greater risk in engaging in high-risk activities with widespread mutual-fund ownership than with a sophisticated group of investors, says Weil Gotshal & Manges senior partner Robert Todd Lang, chairman of the American Bar Association subcommittee on private investment entities.
The brightest minds on Wall Street are not on Wall Street, insists one hedge-fund manager. Theyre with the hedge funds. That might be slightly self-serving, but hedge funds are vacuuming up a lot of talent. Why? Theres that hefty percentage of profits, known as incentive compensation. Not having somebody looking over your shoulder all the time is another perk.
After slugging it out in a big Wall Street firm, many bankers find the idea of spinning off a small shop appealing. Back in 1991, research chief Leon Cooperman left Goldman, Sachs to start the Omega fund, and three years later, Salomon Brothers vice-chairman John Meriwether was forced to resign from the firm but went on to launch Long-Term Capital Management with eight partners, including Nobel prize winners Robert Merton and Myron Scholes. Merton and Scholes famously helped create the Black-Scholes model for pricing stock options. (Dont slap your checkbook on the counter just yet -- Long-Term Capital is closed to new investors.)
Who else preferred to switch rather than fight? Jeffrey Vinik started his own hedge fund in November 1996, shortly after his very public departure from managing Fidelitys hypertrophied Magellan fund, where hed been criticized for making an ill-timed bet on bonds as well as publicly talking up a stock in his portfolio even as he was selling it. Vinik already has an estimated $1.5 billion to play with (after fees, his hedge fund was up 91.6 percent through mid-December). John Hancock Special Equities fund managers Michael DiCarlo and Andrew St. Pierre set up their hedge fund, DFS Advisors, in March 1996 and were featured in a New York Times Magazine cover story nine months later.