Harry Kat questioned why anyone would pay hedge-fund fees. RICHARD THOMPSON

In 2000, Harry Kat got a call from a corporate headhunter who asked whether he would be interested in joining a financial firm that invested in hedge funds—a so-called fund of funds. Kat, a forty-three-year-old Dutch economist, had recently left a high-paying job at the London office of Bank of America to pursue a career in academe. He didn’t know much about hedge funds, but he agreed to be interviewed by an executive at the firm.

Hedge funds are privately owned financial companies that raise cash from very wealthy individuals and institutional investors, such as pension funds and charitable endowments. Unlike banks and brokerage firms, hedge funds are largely unregulated, which gives them considerable latitude in investing their clients’ money. During the past fifteen years, the number of hedge funds has increased from about five hundred to perhaps ten thousand, and some hedge-fund managers have made vast fortunes. Last year, three reportedly earned more than a billion dollars each: James Simons, of Renaissance Technologies; Kenneth Griffin, of Citadel Investment Group; and Edward Lampert, of ESL Investments.

Hedge funds go to great lengths to maintain their mystique: Simons and other managers rarely grant interviews, and the mostly young analysts and traders who make up the funds’ staffs sign confidentiality agreements barring them from discussing their work. The public, denied information about the industry’s methods, has focussed instead on the conspicuous spending it has enabled_,_ seeing in the life styles of the funds’ managers proof of their ingenuity. Steven Cohen, the founder of SAC Capital Advisors, lives in a thirty-two-thousand-square-foot house in Greenwich, Connecticut, and last year reportedly paid $143.5 million for a painting by Willem de Kooning.

In the jargon of Wall Street, hedge funds seek “alpha”: returns greater than those provided by standard market indices, such as the Dow Jones Industrial Average and the S. & P. 500. Investing in hedge funds can be lucrative, but it is also risky: the funds, many of which are highly leveraged, have a tendency to implode when their investments turn against them. (Last week, two hedge funds run by Bear Stearns, the investment bank, were brought to the brink of closure after losing hundreds of millions of dollars, largely in bonds tied to the sub-prime mortgage market.) Funds of funds hold stakes in a variety of hedge funds, so they are somewhat safer. However, as the executive made clear to Kat, investing in them is costly.

Typically, hedge-fund managers charge their clients a management fee equal to two per cent of the amount they invest, plus twenty per cent of any profits that the fund generates. (This fee structure is known as “two and twenty.”) On top of these charges, funds of funds often add a management fee of one per cent, plus a commission of ten per cent on investment gains. Thus, people who invest in funds of funds are effectively paying a three-per-cent management fee plus a “success fee” of thirty per cent—“three and thirty.”

This arithmetic helps explain the astronomical wealth of leading hedge-fund managers, and suggests why even less successful competitors make plenty of money. If a fund manager does well, he gets to keep a large portion of the profits he makes using his clients’ money; if he does poorly, he still receives the generous management fees, at least until his clients withdraw their money, which isn’t always easy to do. (Some funds impose “lockup” periods of several years.) Kat had worked in the financial markets for almost fifteen years, but what he learned about hedge-fund fees shocked him. An investor who puts a million dollars in a fund of funds whose value goes up ten per cent in twelve months would face deductions of about sixty thousand dollars on the gains he makes. “Who wants to pay that kind of money?” Kat asked the executive who was interviewing him. “You can’t seriously expect there to be anything interesting left after somebody takes out three and thirty.” The executive was nonplussed. “I don’t know,” he said. “But they pay it.”

The executive’s firm offered Kat a job as the head of research, but he turned it down. The following year, he began teaching finance at the University of Reading, and in 2003 he became a professor of risk management at Sir John Cass Business School, which is part of City University in London. He continued to think about hedge funds. “When I became an academic, I said, ‘That’s the thing I want to investigate,’ ” he recalled recently. “Is it really possible to generate investment returns to the extent that you can take out three and thirty and still be left with something you can call superior?”

Kat had moved to London in 1996, several years after completing a Ph.D. in economics and statistics at the University of Amsterdam. He worked in the derivatives department of an investment bank, where he traded futures and options—financial contracts in which a buyer has an obligation or option to pay a fixed price for a commodity or a security at a future date. Futures and options are relatively simple derivatives; for decades, farmers and businessmen have relied on them to stabilize their incomes. In the past twenty years, however, new kinds of custom-built derivatives have emerged, which allow investors to make bets on, say, the future creditworthiness of corporations, or the future volatility of the stock market.

Kat became an expert in these complex securities, and by the late nineties he was head of the equity-derivatives desk at Bank of America. He never adjusted to corporate life, though. “If you really want to get up at 5 A.M., get the train, and spend all day in the office for twenty-five years, well, good luck,” he said. “I didn’t want to do that.”

Studying hedge funds proved to be a more satisfying, if less remunerative, challenge. (As a professor, Kat earns less than a hundred thousand pounds a year—about a tenth of what he was earning as a financier.) Aside from their fee structure, hedge funds generally have little in common. A few make long-term investments; most buy and sell incessantly. Some trade individual stocks; others place bets on entire industries and markets. Some rely on human intuition to identify plum investments; many use computer software programs to ferret out profitable trades.

Kat, realizing that it would be nearly impossible to determine the trading strategies of individual hedge funds—the companies would never agree to divulge them—decided to study their results instead. Hedge funds aren’t required to file quarterly reports with the Securities and Exchange Commission, so it isn’t easy to get accurate information about their earnings. However, several financial-publishing companies now collate data on monthly returns which hedge funds supply to them voluntarily, presumably in order to impress potential investors. The databases that these publishers have assembled are neither complete nor entirely reliable, but they include information on thousands of funds, some of it dating back to the nineteen-eighties.

When Kat examined the databases, he noticed that in most years hedge funds outperformed the Dow and the S. & P. 500; they appeared to have produced alpha. But the figures in the databases don’t take into account the unusual risks that hedge funds take. Many funds use borrowed money to leverage their investments; they short stocks; and they speculate on the price of volatile commodities, such as gold and coffee.