Hedge-Fund Frolic: Where There’s Cash …

As one of the few women on Wall Street selling oil and gambling stocks at a mid-sized shop in the late 1970’s, Lee Hennessee, a belle from North Carolina, noticed that her best customers were hedge-fund pioneers-ruthless men like Julian Robertson and Michael Steinhardt, who moved fast and bought stock in bulk. Ms. Hennessee jumped ship and went on to start one of the first hedge-fund consulting companies, the Hennessee Group, and has been tracking the ballooning industry ever since.

“I’ve been in the business since 1980, and it has just been explosive,” she said. “And I don’t think it’s going to go away.”

According to Tremont Capital Management, $60 billion was dumped into hedge funds in 2003-a number described as “staggering” by one analyst-which is almost four times the $16 billion infusion in 2002, and which recently prompted S.E.C. chairman William Donaldson to call for greater regulation in the industry. As more investors scramble to get in on the action, hedge funds are exerting an irresistible pull on the best financial talent, the brightest bankers and traders, portfolio managers and strategists, many of whom who are fleeing investment banks and scandal-ridden mutual funds for the greener pastures of Greenwich, Connecticut, Dallas, Texas, Michigan and Massachusetts-anywhere with an office and an Internet hook-up.

As the cream of the crop is siphoned off into servitude for the ultra-wealthy-who are just about the only people who have access to the hedge-fund world-a two-tiered investment universe is taking shape, with one tier for the super-rich and the other for everyone else.

Departures from places like 85 Broad Street and 1 World Financial Center have become commonplace, filling the “Movers and Shakers” columns of trade rags like The Daily Deal , the industry’s equivalent of Page Six. In the last few months, banking analyst Brock Vandervliet announced that he was leaving Lehman Brothers for the $7 billion firm Andor Capital; Morgan Stanley lost star strategist Steven Galbraith, when he went to Maverick Capital; Credit Suisse First Boston banker Bennett Goodman tried to flee, though CSFB fought back, offering him control of the firm’s internal hedge-fund group; and Nick Rohatyn, son of investment banker Felix Rohatyn and former J.P. Morgan rising star, left to launch the Rohatyn Group in 2002. The New York Post recently reported that defections have led banks to revisit retention packages, which were long out of favor.

Entire desks have walked out of fund companies like Fidelity, fed up with the industry’s bad public relations and disgruntled over compensation. In the words of one industry watcher, the exodus is too widespread to even keep track of: “Every other week, somebody is leaving one of the banks to start a hedge fund.”

The sucking sound emanating from lower Manhattan can be explained by many factors, from better hours and casual dress codes to the promise of independence and autonomy. But the most important ingredient, as it usually is in the financial world, is cold, hard cash.

“The money is just freakin’ astronomical,” said one young fund manager, who went straight from business school to a mid-sized hedge fund.

“It comes down to three words: performance-based compensation,” said another. “They can either make $200,000 to $400,000 flat at an investment bank-or $150,000 with a piece of the upside. Most of them will take a piece of the upside. Performance-based comp is going to continue to suck talent from everyone else.”

“Everyone else” includes the mutual funds, peddled by companies like Vanguard and Janus, as well as those offered by big banks such as Merrill Lynch and Goldman Sachs, where average investors park their 401(k) money or make yearly I.R.A. contributions in the hopes of one day being able to retire. All together, these average Joes poured $216 billion into long-term mutual funds in 2003 and $109 billion in the first quarter of 2004, according to the Investment Company Institute, an industry trade group; they have a median income of $62,100, and $40,000 in mutual-fund holdings. “Mutual-fund investors tend to be reflective of American society as a whole,” said ICI’s Jaime Doyle. “Most of them are saving for their retirement or their kids’ education.” They are also people who have been told to buy and hold, that the stock market outperforms every other investment in the long run, and that if they just hang on, their money will multiply. Regular mutual funds are highly regulated to protect the clueless common folk, whose best hope is that the market continues to go up.

Hedge funds, on the other hand, are beyond the velvet rope of the financial world, private investment partnerships where only the mega-moneyed are invited in. Because their investors are considered “sophisticated”-individuals must have at least $1 million in net worth, and a minimum of $1 million to invest, with some elite funds requiring even more-hedge funds are barely regulated, leaving managers to short stocks when they feel like it and visit whichever financial casino meets their fancy, from the options exchange to convertible arbitrage, junk bonds and currencies. They can borrow heavily-and riskily-and, in return, reap the rewards (or eat the losses).

With Tremont’s hedge-fund index showing 15.44 percent gains for 2003 and 3.42 percent year-to-date, the mathematics of “a piece of the upside” at a hedge fund can be impressive. They typically charge a management fee of 1 to 2 percent, intended to cover basic operating expenses, which is similar to the annual charges at most regular stock funds. The windfalls at hedge funds come in terms of the incentive fee: 20 percent of the profits. That money is retained by the fund manager, to be divvied up by a small group of traders and analysts. Even at a tiny fund, such as Precept Asset Management, which was founded by a young ex–J.P. Morgan trader and his fraternity brother and is reported to have around $64 million under management, the incentive fee on a 15 percent year can be almost $2 million. For the typical small shop which might have only two or three employees, that isn’t bad. On the other hand, if the fund has a lousy year, there’s no Mercedes.

“Just as, at one point, management consulting held an enormous amount of appeal and, at another time, private equity and investment banking and Internet companies had an appeal, frankly, the hedge-fund space is fairly attractive right now. The revenue model within the hedge-fund industry is very strong,” said Philip Sheehy, who was just brought into the recruiting firm Warren International to help tap into hedge-fund defections by heading up a new alternative-investments practice. “An industry or area that can afford to pay the most is going to naturally attract the strongest high-powered individuals.”

His advice to clients? “Find a revenue stream and align yourself with it.”

In a year when the big banks saw a rebound in earnings-and their C.E.O.’s paid themselves record salaries-money might not be the only factor. Life at sell-side firms has grown more complicated. Analysts are fed up with the specter of investigations by the S.E.C. and the state attorney general, intended to protect the little investor from conflicts of interest. Research reports are published with page-long disclosure checklists; in some cases, equity analysts are told that, if they make a bad call or find themselves on the wrong side of new ethics rules, their firms won’t back them up. Who needs the hassle? Anyone who is good enough will be tempted to make the leap.

“If you have a lot of good ideas and you’re a proven quantity as a portfolio manager, where would you rather be? For most of them, a hedge fund is probably the right answer,” said Andrew Lo, a professor at M.I.T. who studies hedge funds for a living and who also runs one on the side, adding, “That’s not to say that only the dregs are left.”

In a somewhat ironic twist, the very regulations that are intended to protect and assist mom-and-pop investors might be putting them in the awkward position of only having access to the B-team of investment brain power, the people who couldn’t land cushy hedge-fund gigs. It used to be said that those who can’t do, teach. A more current version might be: Those who can’t do, manage mutual funds or toil at investment banks. It is surely one of the unintended consequences of the pro-investor backlash against the excesses of the 1990’s.