Coggan Philip - Guide to hedge funds: what they are, what they do, their risks, their advantages

I n a small room on the banks of the River Thames, on the site of an old dock, Meg Ryan and Jamie Lee Curtis stand in air-conditioned splendour. All day long, they calculate and analyse and send orders to some 1718 traders sitting outside. No, the American actors have not taken up a second career. Meg and Jamie are the names of two of the computer servers in the headquarters of AHL , part of Man Group, one of the largest hedge fund groups in the world. AHL runs billions of dollars on the back of what those computers decide to do.

In his 1980s novel, The Bonfire of the Vanities, Tom Wolfe said the investment bankers were the masters of the universe. That description is now out of date, as Wolfe himself admits. Hedge fund managers have assumed the mantle.

Those men (there are relatively few women) who run the funds have the power to bring down currencies, unseat company executives, send markets into meltdown and, in the process, accumulate vast amounts of wealth. A survey by Alpha, an industry magazine, found that the worlds top ten managers earned almost $10 billion between them in 2008, with the top four taking home or in their case, several homes more than $1 billion each.1 Some of the leading managers have become patrons of the art market, helping drive prices of contemporary artists to new highs.

But with this power has come immense controversy. During the credit crunch of 2007 and 2008, hedge funds were accused of exploiting the crisis, driving down the shares of banks and increasing the risk of financial panic. Their high earnings were seen as unjustified, their activities as mere speculation, and their continued existence as a threat to the financial system. European Union officials and parliamentarians vied to create the toughest set of regulations for the industry.

Meanwhile, the industry suffered a liquidity crisis as banks cut their lending to hedge fund managers. This coincided with poor investment performance (by the industrys standards), causing clients to demand their money back, and the fraud of Bernie Madoff (who did not strictly speaking run a hedge fund) increased the rush for the exit. The industry suffered the loss of around one-third of its assets.

This was a big change for a sector where the best fund managers were so sought after that they could afford to turn investor money away; being on their client list was a badge of honour akin to joining the more exclusive gentlemens clubs. Madoff (who managed money on behalf of some hedge funds) was adept at using exclusivity as a lure to clients; initially, they would be turned away, only for Madoff to find some capacity after a short interval. Indeed, some would say that investors should be suspicious of any manager who is willing to take their money the equivalent of Groucho Marxs famous saying: I wouldnt want to belong to any club that would have me as a member.

Hedge funds have virtually set up an alternative financial system, replacing banks as lenders to risky companies, acting as providers of liquidity to markets and insurers of last resort for risks such as hurricanes, and replacing pension and mutual funds as the most significant investors in many companies. Some, such as Eddie Lampert, have even bought companies outright, notably the retailing groups Kmart and Sears; when Daimler sold its Chrysler arm in 2007, the buyer was not another auto giant but a hedge fund/private equity group, Cerberus. They are like wasps at a summer picnic, buzzing round any situation where a tasty feast might be available. If an asset price rises or falls sharply, hedge funds are often to blame. And even when they are not responsible, they will be blamed anyway.

The new managers also have a different style. Unlike traditional bankers, they prefer more casual forms of dress open-necked shirts and chinos are more common than tailored suits. They run their businesses from different places Greenwich, Connecticut and Mayfair rather than Manhattan and the City of London. And they have different aims, often rejoicing when prices fall as much as when they rise.