HEDGE FUNDS--OR, HOW THE RICH GET RICHER

By JOSHUA COOPER RAMO

It is 9:30 a.m. on Wall Street. Four blocks from the New York Stock Exchange and eight stories up, fund manager James Cramer is up and shouting with the market bell, greeting the first move of the tape with his usual salute: "There goes Swifty!" Cramer picked up the incantation at a dog track in his youth (Swifty was the mechanical rabbit), but he's used it to start trading since the day two years ago when, he says, he had "a huge up day" after muttering the phrase. Cramer, who manages hundreds of millions of dollars for a group of 38 rich families, isn't above a little superstition.

Of course it's not superstition that his clients are paying for. It's his numbers. Cramer runs a hedge fund, a Wall Street investment vehicle for superrich investors looking for hyperterrific returns in all sorts of economic weather. While most investors bet on the broader market or particular stocks, wealthy clients want to protect their pile by "hedging" their risk with funds that adjust to economic conditions as fast as the market changes. With stocks teetering at record highs, demand for that sort of insurance is blossoming. The best hedge funds have become as exclusive as Augusta National, and hot managers are the rock stars of the investing world. Among the sexiest: George Soros, whose Quantum Fund has tallied a 33% annual return historically, vs. 7% for stocks; and Julian Robertson, whose Tiger funds are to Park Avenue what fur is to Gstaad.

The initial aim of the funds, which were developed in the 1950s, was to protect against market risk and earn greater return in times of sluggish stock-market performance. The notion had a simple elegance: If rich investors could cash in during booms by betting on winners, couldn't they profit during busts by betting against losers? The first funds were fairly simple, usually holding 50% of their assets in long-term investments that were expected to rise over time, and 50% in short positions in stocks or bonds that were considered overvalued. (In a basic short position a fund sells borrowed shares at one price with plans to repurchase them at a lower price after the stock falls.) If the market rose, they still had an upside in the winners; if it fell, they profited from short sales. The idea stuck: there are nearly 3,500 U.S. hedge funds today, with equity of $134 billion.

But hedge funds now describe a kind of management that is far more aggressive. Lawmakers insist that clients be "experienced with risky assets" and rich enough (in some cases, at least $5 million in investable assets) that they won't be wiped out by some slap-happy manager who bets everything on the Thai baht. Hedge funds shine in volatile markets. Says Robert Jaeger, president of Evaluation Associates Capital Markets: "The whole idea behind hedge funds is to have some money invested with people whose returns aren't going to be totally determined by whether the market is up or down. It's a different risk."

If hedge funds look like a good deal for their millionaire clients, they are even better for fund managers. Unlike mutual-fund managers, who generally work for a fixed compensation tied to the size of their fund, hedge managers get paid on two very lucrative tiers. They collect 1% to 2% of their funds' assets as a management fee and, the real jackpot, anywhere from 10% to 30% of their trading profits. At larger funds, where those profits can run into hundreds of millions, that means multimillion-dollar paychecks for fund managers.

While Soros' "macro" fund stalks giant economic trends, Cramer invests and makes his money mostly in U.S. stocks. Roughly half of his $315 million fund is locked down in stocks he believes will outperform the market over the next decade. The other half Cramer and partner Jeff Berkowitz trade every day, with a feverish enthusiasm fired by the glee of making the right bets and the crunching agony of picking a loser. In the course of a day's trading, the firm will be in and out of 50 stocks, betting millions on tiny ticks of the tape. Cramer, whose 22% compound annual return over nine years marks him as a winning investor, is perhaps an even greater show. He spends most of the trading session jumping up and down out of a very worn chair, shouting orders at the calm traders who surround him. Says Cramer, who abandoned the security of Goldman Sachs for life as a trader: "Hedge-fund managers used to seem like Errol Flynn to me."

A steadily rising market, however, can make a hedge-fund manager look more like Dumbo. In the past two years rich investors would have done better putting their money into indexed mutual funds, just like ordinary folk. That's to be expected, says George Van, a hedge-fund adviser. Hedge funds, after all, are designed to protect against bad times, which means forgoing some riches during good times. Van's research shows that in the six quarters since 1988 when the market has gone down, mutual-fund investors have lost an average of 24%, while hedge-fund clients have made 3%.

So how much are average fund buyers missing by being locked out of these rich investors' clubs? Cramer, for one, says most investors can get everything they need from mutual funds: "I sure wish I could tell you that the public should be in hedge funds. But I think it's better for most people to have their money with a guy like Will Danoff at Fidelity than with some crazy man who's running around shorting everything in sight," he explains minutes before the market opens for another up day. Then, with a clap of the hands, it's off to the trading floor and the seductive promise of the dog track: "Let's go make some money!" There goes Swifty.

--With reporting by Lisa Granatstein

With reporting by LISA GRANATSTEIN