On a baking summer's day, Bob Metzler, former vice-chairman of Morgan Stanley Europe, sat in his Chelsea townhouse, typifying the retired American banker. His brown loafers gleamed. His khaki shorts were freshly ironed. On the shelves were busts of Churchill and books about Bonaparte; on a table in front of him lay brochures detailing properties in the West Indies.
Metzler is funny, clever and speaks in a sardonic growl. As we talked, he was enjoying himself, playing the man who's seen more economic cycles than Gordon Brown's had prudent thoughts; specifically, he was discussing the burgeoning - and, say some, potentially disastrous - hedge fund phenomenon: "A prime investor said to me, 'A hedge fund is like an opera; it's beautiful - and then it's over.'"
Over? Hedge funds are never out of the news. It was a group of hedge funds that provided Malcolm Glazer with the extra money he needed to take over Manchester United. It was a London-based hedge fund director, Elena Ambrosiadou, who "compensated" herself with £15.9m and thus became the highest paid businesswoman in Britain last year. It was Chris Hohn, a managing partner of a British hedge fund, who in May became for the Germans the unacceptable face of Anglo-Saxon capitalism when - quite rightly - he savaged a major German company, Deutsche Borse, for its incompetence.
It was Harvey McGrath, chairman of Man, the world's largest listed hedge fund company, who in July declared that, "The hedge fund industry is characterised - wrongly - by greed, ego, risk and nonregulation." It was George Soros, and his Quantum hedge fund, who bet against sterling in 1992, decimating the pound and making himself more than $1bn in a day. And it's the mushrooming of the hedge fund industry - it controls a trillion dollars worldwide, and where there were only 800 hedge fund companies there are now 8,000 and rising - that is provoking suggestions that a horrible blow-up is in the wings: with a crashing hedge fund sector might come a crashing capitalist system.
Sir Andrew Large, deputy governor of the Bank of England, has warned that hedge funds have "added to the risk of instability arising through leverage, volatility and opacity". And the Bank of England's financial stability review, published in June, spoke of "market contacts" and their concerns about "potentially excessive enthusiasm" in relation to hedge funds. To some, this might recall the "irrational exuberance" that Alan Greenspan, chairman of the US Federal Reserve, detected in the technology bubble of the 1990s when internet and technology stocks soared to lunatic (and unsustainable) heights.
So it's quite an interesting business, really - particularly when you consider that hedge funds are arcane, mysterious things, understood by few.
Of course, hedge fund operators (and users) believe that hedge funds are far more efficient - almost revolutionary - vehicles for allocating capital than other investment vehicles. They believe they are essential tools for energising slothful managements. They say talk of disaster is hyperbolic. They're sure they create portfolios that are less risky for their investors. They point to consistently high returns. And they note that some of them are eager to use their wealth for philanthropic purposes, likening themselves to the Levers, the Rowntrees and the Cadburys of that other quick-fortune-making age, the Victorian.
But it's also eye-catching that, for example, Jeremy Herrmann, 75% owner of Ferox, a London hedge fund, paid himself £11.5m last year, while over the pond Ed Lampert, of ESL investments, paid himself $1bn, and Steve Cohen, of SAC, took home $450m. James Stewart, of Renaissance Technologies, trousered $670m, having charged his investors a 5% management fee and having taken a 44% proportion of the profits he made them. They probably didn't complain too much; Stewart gave them a 24.9% return on their investments, which compares well with what your building society will be paying you. But no wonder hedge funds provoke what one banker called a "visceral reaction".
What are hedge funds? Well, in 1949, a former financial journalist called AW Jones invented them. Jones wanted to make his investors money, but also to make sure they didn't lose any - to "hedge" his bets. Most investment funds are "long only"; in other words, managers put money in stocks they think are good, and hope they go up - "a naked one-way bet", according to Neil Wilson, managing editor of EuroHedge, a magazine that tracks the industry.
Jones's wheeze was both to "go long", and to "short" some shares: "shorting", essentially, means identifying shares you think are overvalued and betting that they will go down. You - or Jones - borrow (for a fee) a whole bunch of these dud shares, and agree to give them back at a later date. You promptly sell them at their current price and re-buy them when, as you expect, they've gone down. For example, you sell them at 100p and buy them back when they're 50p, thus making a pretty profit - the only problem being when they unexpectedly go up, as happened with General Motors stock earlier this year (this, one leading European banker told me, gave the system a fright). But assuming your "short" works, the profit you make on that covers your "long" shares if they aren't doing well. But Jones also borrowed ("leveraged") money to buy more "long" shares, and he was extremely good at stock picking.
Now there are loads of different hedge funds, dealing with all sorts of instruments: statistical arbitrage; emerging markets; algorithmic trades, you name it. They're usually based offshore and, because of that, not regulated. What's common, though, to all the hedge funds that EuroHedge typically tracks is that they have the ability to "short" (something not permitted to regulated, onshore funds) and the ability to "leverage" or, as Wilson puts it, "to invest more money than they manage" - again, something permitted only to a much-lesser degree to onshore funds. (The possibility of over-leveraging makes many people nervous of hedge funds; it's what caused the collapse of Long Term Capital Management in 1998, an event that rocked the banking system. Hedge fund enthusiasts, of course, point out that virtually every house-buyer in Britain is "leveraged" to the skies.)
The funds are limited to professional investors. This is not you or me, but it can include the pension funds that run our money. Some of these have been in hedge funds for years: others - attracted by the fact that "long only" funds lost 45% in the bear market of 2001-2002 while hedge funds made money - are pouring in. Even the Catholic church has money in hedge funds now: and once they show up for the party, says Metzler, "you know something's pretty long in the tooth".
Long in the tooth, maybe, but investment bankers are flocking to start hedge funds. One reason is that they charge high fees: "1 & 20", or "2 & 20" - that is 1% or 2% of the assets managed and 20% of the profits made. So, if you're a bright young trader or a sharp young analyst - the classic mix for a start-up - where better, in the investment world vernacular, "to monetise your skill sets"? And as already existing hedge funds often have all the money they need, and are closed to new investors, new funds can continue to charge high fees without fear of competition.
Not everybody likes hedge funds, of course. To some, they're quintessentially parasitic, making money out of money and prime examples of Keynes's scornful description of professional investment as like "those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole."
To Professor Robert Wade of the London School Of Economics, "The underlying problem is not hedge funds but the systemic instability of the financial system generally - itself a result of a combination of deregulation and the ability of the US to run its huge deficits, which pump up the amount of international financial liquidity."
One self-deprecating English banker told me, "We're not keen on them as an asset class, you know, 2 & 20 - it might drive them to do the wrong thing. And a lot of what they do is time-sensitive, and we're not clever enough to deal with that. We like to sleep easy ..." But it's true, as one City dealmaker told me, that, "You must remember that all hedge funds are trying to make money for themselves and their investors." That's what monetising your skill sets is all about.
Unfortunately, hedge fundies' skill sets seem not to include communication. It's incredibly hard to get a hedge fund manager to talk. Why? They are, I was told, "shy of media interest" - indeed, one City PR said that though he'd love to put me in touch with some big cheeses, his "brief was the precise opposite". And Neil Wilson told me that many were genuinely afraid of kidnappers. However, two of the highest fliers, Paul Marshall of Marshall Wace, and Crispin Odey of Odey Asset Management, were willing to speak. They are both extremely good at their jobs - paradigms of what Bob Metzler calls the "exceptional people" who really understand hedge funds.
Marshall is 45, educated at private school and Oxford, where he read history, and at Insead, the business school. He and his partner, Ian Wace, are reported to have shared £26m in pay and dividends last year. Marshall's offices are bright and modern, with fantastic views of the Oxo tower, the Thames and Nelson's column. He has a fresh face.
The morning I meet him, he is a mite annoyed with the Guardian, which has run a piece sniping at Arki Busson, separated husband of Elle McPherson, very wealthy hedge fund operator and a man who heads a charity, Ark, that's involved in City Academies. Marshall supports Ark; he and Wace gave it £2m last year. What irritates him is that when something like Ark is written about, he and his pals are called "businessmen". They are, he says, but not in relation to charities such as Ark. He says he is giving something back; it is, he believes, the way society is moving - towards the US model: "Gordon Brown has done some very good things in his tax reforms to help charities."
He is, in fact, a Liberal Democrat, who was once a researcher for Charles Kennedy, believes there is a "good chance" of the Lib Dems being in government in 2009, and is funding the Centre for Reform, "the only Liberal thinktank". He tries to avoid "lavish spending on my family", a French wife and two teenage children who want to work in the music business. He lives in the house in Mortlake, southwest London, that he's had since 1989; he also has a house in France and one expensive painting. Otherwise, he has "a strong Christian faith", and buys the work of Charlie Mackesey, a Christian artist, and John Morley.
But he was clear as to why there was a "visceral reaction" to the hedge fund industry: "I think it's probably a mixture of (a) the amount of money people can earn, and that's 90% of the answer. And (b) the slight mystery cum secrecy about hedge funds and how they operate. Plus the perception, which is partly true and partly false, that hedge funds are very short-term things. But the overwhelming issue is that hedge fund managers earn a very great deal of money. And for some reason people don't resent paying David Beckham a lot of money, but they do resent paying hedge fund managers a lot of money."
Implicit in that is the conviction that good hedge fund managers are the Beckhams/Rooneys of finance. Implicit in that, too, is the more general belief that there just aren't enough good managers to run 8,000 companies. Marshall agrees: he believes there'll be a "winnowing out". Nevertheless, he is clear that good hedge funds are far better at making money for investors than the City as it used to be. If you want to talk about people being overpaid, he says, you should look back to the City of the 1980s.
Crispin Odey feels much the same. Odey (public school and Oxford, where he, too, read history) is, of course, as sharp as a Stanley knife, but has an amiably bumbling manner. "I set up the thing in 1991," he says, "and I had £120,000 of savings and I stuck those in the formation of the company - with Nicola, my wife. And she paid me 10 grand, I think, a year - which was very nice of her." He also had £20m from an American pension fund and early on got money from financiers such as George Soros and Gilbert de Botton - "hard taskmasters. But you actually want difficult clients with a healthy level of scepticism".
Within a year, Odey made more than £19m for himself. Odey Asset Management now controls £2bn, and reportedly paid Odey £8.2m last year. Equally, in 1994, as he'll affably tell you, he made a bet on War Loan that went wrong and found 90% of his investors taking away their money. He didn't get any new money for five years; his "long only" side kept him going.
Odey's offices are in an elegant town house in Mayfair. When he takes off the jacket of his grey suit, there are salmon pink braces over his blue-and-white striped shirt. His face is reddish and beaming. His hair is schoolboyish in its floppiness. On the wall of the meeting room is a painting of a domestic scene.
"Do you like that? I mean, it is quite good and bolshie, isn't it? We all know those grumpy girls."
Why, I ask, won't hedge fund managers talk to the press? There are, he says, no upsides. They can sell only to professional investors, so there is no "retail element". But, I say, to be honest I was wondering more about the perception that hedge fund people are rapacious, vicious capitalists, all of whom personally earn far too much money.
"Well," he says, "those things are true, actually." He laughs. Mostly he's joking, but he's probably also alluding to the accusations of short-termism - of just driving up or, more likely, driving down shares to make a quick buck. Or, perhaps, to events such as Philip Green's assault on Marks & Spencer, when the M&S board complained that they no longer knew exactly who their shareholders were, so prolific had the borrowing been in their stock by hedge fund operators.
He also feels the area is overcrowded: "I don't even know if one's good enough oneself, actually. But the truth is, if you look in the City you can see there are probably only 20 people who have got a record that is really observable and outstanding over a long period of time. And of those 20 people, they will have periods of two or three years when they don't do as well as other people. For me, I don't find hedge funds per se very exciting - I think they're just a structure. The exciting thing is the mind behind it - as always."
Odey has survived. Not all hedge funds have, and one rich man made the point to me that if you looked at "survivorship rates" - or rather at the number of funds that had failed - then hedge fund returns weren't that great. Both Odey and Marshall took the point, but then both run superior operations. It's just like picking stocks: you've got to pick the right hedge fund. That's more difficult now, argue Metzler and others, because you've got too many people trying to chase the same deals. And as the key is to be able to get out of a bad position quickly, you can find too many not-so-nimble operators stuck with illiquid holdings.
Odey liked the pioneering days, when very few people really understood hedge funds and those who set them up were people with a "history of talent. I loved it best when it was lots of little people doing their own thing ... What's needed is to allocate capital and to allocate it fearlessly" - by which he means putting in huge amounts of money in the hope of making even huger wodges. "And what [had] happened in the UK was that it became dominated by four or five major houses that were much more about asset gathering than about trying to allocate capital."
Marshall takes the same line as Odey. Essentially, he says, the major investment funds were happy just to deliver what the Footsie index delivered plus 1% if you were lucky - and you, the investor, were expected to feel jolly grateful for it. Marshall Wace was set up to do better. "What I'm saying is the hedge funds' growth is a response to that unsatisfied and very pissed off client base."
His response is an attempt to "generate alpha" -ie, get very, very good returns. (A Marshallism: "In theory, there is no alpha. It's all beta because somebody's positive alpha is somebody else's negative alpha.") The competition is "incredible. That's why the excess returns of cash from the industry as a whole has gone from 14% when we started in 1997 to 4% last year." But Marshall Wace has done very well. It started its Eureka fund with €60m. Now it has €2.5bn in it. Since 1997, he says, Eureka is up 270%; the market is up just 10%.
Marshall, though, is aware of another caveat raised by critics - that hedge funds are becoming too big to manoeuvre quickly, as they must. In fact, in 2001 Marshall Wace decided it was too big: "We didn't know we were too big. We just felt it might be a challenge. So we gave our investors back €500m." That was when the fund stood at €1.7bn; since then, Marshall believes they've developed new strategies that have allowed them to run more money.
Well, he would say that, wouldn't he? As Metzler says, what typifies hedge fund managers is that they have "enormous egos. I mean, they're very bright, very smart, mathematically astute. But you have to have a lot of ego." On one level, Marshall - for all his level-headedness - exemplifies that. Talking about philanthropy and why many hedge fund operators feel drawn to it, he said: "Someone said to me, and I think it's true, that if you make a lot of money very quickly, you're less attached to it than if, for example, you inherited it, if you waited around for 60 years for someone to finally pop off and finally get your £20m. And also if you don't have the confidence you're going to carry on making it, you're going to be much tighter."
Confidence you're going to carry on making it? Isn't that dangerously close to hubris? Marshall is aware of that. For him it's crucial that a firm isn't dominated by one man. His isn't; and Soros, for example, was surrounded by bright guys - Druckenmiller, Roditi, Rogers - all of whom were as sharp as he was.
But there is the example of Julian Robertson, who ran the Tiger Fund. "He was a tiger," says Marshall, "and there were lots of tiger cubs. But he was dominant." Metzler picks up the theme. "If you started in the 1980s and went through the 90s, Julian Robertson was the king. And he blew up. He became a true believer in a few situations that killed him."
In 1980, Robertson had $8m under his control; at his peak he was running $26bn. But he believed in a "few situations". He stuck by them. And well, let Metzler tell the tale: "He was warned - warned, warned, warned. And he paid no attention. And he blew up. And you couldn't get any bigger."
Robertson has his defenders. According to Neil Wilson, "Robertson was fundamentally right about the tech bubble - but the market took him out before he could be proved right. He'd have made a fortune." Metzler has an answer to that: it's always your fault. Robertson had made bad calls on the yen, on technology stocks and in his obsession with US Airways. No one was able to tell him he was wrong. Still alive, he now worries about the US housing market.
There are now voices saying there's something wrong with the growth of the hedge fund industry - the Bank of England's financial stability review noted that inflow of $24.6bn had gone into hedge funds in the first quarter of 2005, a sum 50% higher than in the fourth quarter of 2004. The review also worried about investors accepting "higher risks" in search of "higher returns". It said that "difficulties in ascertaining the nature and scale of exposure may impede the risk management of some firms should a credit event occur". It would probably also worry about recent reports that some hedge funds have put rather too much money into catastrophe bonds - bonds that normally pay out large sums but that, faced by the devastation wrought by Katrina, are going to cost them plenty.
Against that, Odey thinks indebtedness and the housing market pose greater dangers. And someone like Stu Bohart, an American who's head of prime brokerage at Morgan Stanley Europe, thinks "Ups and downs of 3% to 4% a month should not shock people in any investment area. If you look at just the long only market, you generally get at least a month when you drop 4%. But there is never a panic. But hedge funds drop 4% in a month and it's 'Good night, Irene, the money-making machine is broken.' But there was no money-making machine - it's asset management."
Bohart is almost scarily clever and very charming. It's a Friday when I meet him, and he looks a little tired, but he talks at a rate that makes Martin Scorsese sound ponderous. He thinks hedge funds are on the way to becoming a new form of "modern asset management" and he believes mainstream press coverage is absurd:
"There are plenty of people who have done well hedging out risk. But it always comes down to this black and white: hedge funds are good or bad. They're neither. They're just a group of people who run money in a slightly different way. And it's very rewarding to me to be close to these managers, to be very close to some of the most aggressive, intelligent people in the investment industry and provide them with services. They make our business better because they are highly demanding. It really is the best of the crop that ends up in hedge funds. Not always, but ..." So good are they that, according to Marshall, "When it all hits the fan, and there is a big fall-off in the market, clients phone us and say, 'Are you sure you've ringfenced your money at the prime broker? Are you sure about the solvency of Morgan Stanley?' They're not worried about us."
As for Odey, he has a substantial stake in the established order. His father-in-law was vice-chairman of Barclays, one brother-in-law runs Barclays and another "is a very good fund manager at New Star". His wife is chief executive of JO Hambro Capital Management, and is said to have earned £3.5m last year. They have two boys, of 11 and six, and a daughter of eight. Odey shoots, fishes, plays golf and tries to "have a nice time, really". The money motivation evaporated when he made his £19m back in the early 1990s. What he relishes, he says, is that "the fun thing for me is analysing and understanding where a company is in its [financial] life and what you can do with it at that point."
But that's what all those 8,000 funds are trying to do, not all of them run by people as clever and effective as Odey and Marshall. And they live in a world, as Metzler puts it, "that's awash with money". And where there is money, there are always going to be people who want to "monetise their skill sets". And there'll always be investors who want sky-high returns.
Why? Metzler knows: "It's greed. Greed. I mean the returns ..."
So is greed good?
"I don't think it matters if it's good - it's always there." He muses. "The central problem is most of the [hedge funds] have a pattern: they're hot and they accelerate and then it's over. The situation is not catastrophic. But some of the hedge funds are going to lose serious amounts of money. Some of those who did very well are doing very poorly now. And they're going to hurt. But that doesn't mean that they can't get back."
And "they" - the best and the brightest - will always try. As I leave Odey, I pass two of his 45-strong staff. It's dress-down Friday, and an American boy with gelled hair and an open-neck shirt is talking to a slender, short-haired young woman in jeans and a red sweater.
"They have," he says, "capital of £2.13 billion."
And that's the way of the hedge fund world.