Hedge funds operate with nearly free rein and on murky ethical ground, bullying banks and recruiting the best – all to questionable results

Hedge funds, those financial funds run by extraordinarily rich men, are going mainstream. Not content to be investments for just the super rich and super connected, they are starting to offer services to the average investor.



A good example comes this week from hedge-fund manager Bill Ackman, who is famous on Wall Street but not yet a household name. He wants to start a small fund with a public listing to collect money from the public that he can then invest.



Ackman's new fund itself is not a hedge fund, but because he is a giant in the hedge-fund world, regular investors may be attracted to the mystique of a world that usually locks them out.

Hedge fund bullies



Let's be clear: the average investor should not be too excited. Hedge funds are certainly powerful, but it is not clear they all deserve the power or are using it well – not based on performance at least.

When I was a trader at a big bank, several years ago, I learned about that power of hedge funds. In a moment of luck, I made $1m in 10 seconds trading with a large hedge fund. They made a bad bet – buying bonds from me that dropped in price seconds later. I was up a cool $1m and they were down $1m.

That didn't sit well with them. Hours after the trade I received a tap on the shoulder from a senior member of my bank, asking me to rewrite the trade and give half of my profit back to the hedge fund.

Bill Ackman wants to start a small hedge fund to collect and invest money from the public. Photograph: Brian Snyder /Reuters

My bank was doing the fund a favor. The hedge fund was an important and connected client, and the trade was, well, embarrassing to them. That embarrassment might jeopardize other business with the bank, threatening millions in fees. Over my objections, my bank renegotiated the terms of the trade to give the hedge fund a better price.

It was a perfectly legal, but unusual concession. It was also a lesson: hedge funds can even bully the biggest banks in the country.

Where the real power lies

Hedge funds, to the regular citizen, seem shadowy and strange. Super secretive, absurdly paid, massive investment firms that manage, in total, close to $2.2tn. Who are these guys and why do they deserve the royal treatment and enormous pay?

They're bad boys of finance, with lots of money. Hedge fund managers are often glamorized as super wealthy hotshots with special insight into how to invest. They are also generally rich. Collecting-modern-art rich. Last year, the total pay of the top 10 hedge fund managers was $15bn. One gentleman, David Tepper, was paid $3.5bn.

Wall Street increasingly attracts PhDs in fields such as mathematics and physics, as well as international political leaders and officials. Photograph: Cameron Davidson/Corbis

Because of their reputations, hedge fund managers can collect money – anywhere from a few million to a few billion – from rich people and big institutions like pension funds and college endowments. Demand is only increasing; in the last 20 years, hedge funds have collectively grown by 1,000 times.



'Sophisticated investors'



Hedge funds have almost complete freedom, for one reason: the government allows them to approach only the very rich, with assets of at least more than $1m – and usually, over $10m. These are called "sophisticated investors". The assumption is that lots of money gives you enough investing knowledge to lose it however you'd like.



Facebook Twitter Pinterest Michael Steinberg, a portfolio manager at the SAC Capital Advisors hedge fund, and his lawyer exit federal court in Manhattan. Photograph: Eduardo Munoz/Reuters

Because hedge funds deal only with the sophisticated investor, they have almost no restrictions on what they can invest in, or how they can invest, short of breaking the law. They can put their money in everything from the stock market to farmland to gold mines.

For the privilege of exclusivity, they charge their "sophisticated investors" huge fees. The general rule is "two and 20"; the hedge funds pay themselves 2% of all the assets they oversee, and 20% of any gains in a given year.

For that kind of cash, you'd expect them to deliver.

Why the rich love hedge funds: the edge



Are these sophisticated investors making sophisticated investments? It's hard to find the proof that they are.

By many measures – and it is hard to measure – hedge fund returns are pretty much just average.

That hedge funds can charge such high fees for such average returns has economists and many others confused. It's not exactly rational. Theories abound.

People may invest in hedge funds for many reasons, but there is something simpler at work: the idea that you'd rather be with hedge funds than against them. Sophisticated investors assume hedge funds have an informational edge, either legal or illegal. They're so well connected and so informed, the thinking goes, that they must know something we don't.

Facebook Twitter Pinterest Hedge-fund manager Raj Rajaratnam convicted of insider trading in 2011. Photograph: Emmanuel DunandAFP/Getty Images

It is not a bad assumption, as far as assumptions go.

Hedge funds trade in the gray area of information



Information is everything to trading. Knowing more, knowing it quicker, or being the only one to know, will make you money. It’s often the only guaranteed way to try to outsmart the markets.

Hedge funds strive for that edge, certainly the legal one. Every trader does. Yet with less regulation and less observation, hedge funds can do it in a far more aggressive manner.

They do it by hiring the best and the brightest. Some have more PhD’s than many college math or economic departments.

Information has a direct relation to currency on the New York Stock Exchange. Photograph: Spencer Platt/Getty

They do it by trying to know everything about whatever they are trading. A country has laws making it illegal to run polls the week prior to elections? No problem. Hedge funds will hire their own pollsters for private polls.

They do it by hiring, and paying very well, people with connections. The number of former officials and present officials who have hedge-fund ties is staggering. It is almost now considered normal. Leave public service related to politics and finance? Go directly to hedge fund. Do collect large payment.

Larry Summers, after his stint at the Treasury, and before his job of chief economic adviser to President Obama, spent two years working for one of the largest and most opaque hedge funds, DE Shaw. He was paid close to $5m for that work.

Wall Street is about collecting and trading in information. Yet the rules concerning trading in information, what is legal what is illegal, are notoriously gray. So hedge funds hire teams of lawyers to navigate and at times push right into the gray.

Larry Summers worked for DE Shaw after heading the Treasury under the Clinton administration. Photograph: Alex Wong/Getty Images

Sometimes hedge funds go from fiddling around in the gray, and just allegedly break the law. This year the hedge fund SAC Capital paid a $1.8bn fine stemming from charges against eight of its employees for insider trading. Two years prior, the founder of the firm, Steve Cohen, did well enough to collect a paycheck worth $1.4bn.

Main Street isn't ready for hedge funds



Now hedge funds are trying to expand their services, hoping that their reputation for having an edge will also appeal to investors who are not ultra-wealthy. There's even a hedge-fund TV channel for advertising their financial wares.



Before throwing in any money, the average investor should be careful. Hedge funds are opaque. Don't put in any money you can't lose.

The biggest cautionary tale



Keep Bernie Madoff in mind.



Madoff was not technically a hedge-fund manager, but he acted like one. His fund’s eerily consistent strong performance and his reputation as an investment hotshot attracted lots of money, and many investors who were convinced Madoff had an edge. His returns also attracted skepticism that perhaps his fund was doing something illegal.



The skepticism was justified. Madoff was just outright running a $17bn Ponzi scheme:

According to reports, some of those who put their faith in Mr Madoff suspected that he was engaged in wrongdoing, but not the sort that would endanger their money.

Many of the losses came from investors who were in no position to suspect Madoff was doing anything illegal. Even though they had money, they weren't sophisticated enough. In the end, no one was.

That's not to say all hedge funds are bad. Not even close. There are thousands of hedge funds, and there was only one Bernie Madoff.

The main lesson, instead, is to know as much as possible about where your money is going, and don’t let the allure of secrecy fool you. In a mutual fund you can see every stock. In a hedge fund, you often only have a black box built by someone with a reputation.

The bottom line: investors, sophisticated or not, can't know in detail what many hedge funds are doing. But as long as the mystique exists, perhaps many don’t want to know.