They have been called the masters of the universe. You don’t know who they are. You don’t know what they do. Yet they touch your life. In fact, they’ve had a dramatic effect on your existence for the past 15 years.

Just who, and what, are hedge-fund managers?

When the Conservatives were kicked from office in 1997, few people knew what a hedge fund was and fewer cared. Now, even well-informed people are nagged by the same insecurity: who are these mysterious figures? To some they are part of the superclass, overtaking you in the race for the best schools and overpaying for the house you presumed was yours. To some politicians, they threaten the financial system. The sheer scale of their wealth is upsetting. How can anyone be paid a billion pounds a year? How can you justify the fact that at the unofficial exchange rate, the top 25 hedgies earn enough to fund Zimbabwe’s education budget for the next 20,000 years?

We are told that what they do is high risk, that they are secretive and either lightly regulated or not supervised at all. Germany has been trying for a while to warn other rich nations that hedge funds threaten the stability of global capitalism. Tom Wolfe complained in a recent essay that these people – hedgies, private-equity managers, stock and bond traders, and property developers; but particularly hedgies – are supremely arrogant, too. He describes one “lone-wolf entrepreneur” who keeps a respected charity fundraiser waiting outside his office for an hour, listens to her pitch with his feet up on his desk, utters just two words – “not interested” – and offers no farewell.

At a posh apartment block in New York where they check up on prospective buyers, the board wants to reject those with too much money, not too little. It would screen out hedgies.

Hedge funds are the adult magazines of finance: perfectly legal, but top shelf. American regulators have just backed down from a plan to stop you investing in one unless you have £1.3m in savings, which supposedly means you are savvy enough to take the risk. Yet it is increasingly likely that your pension is invested in one. And your neighbour, who does not have £1.3m, might already be slipping them money.

People are finding ways to get into hedge funds, even though regulators have discouraged them. And perhaps these early adopters have a point. The aim of a hedge fund is to make money in good times and bad, and as the economic sky darkens, this is not a bad time to learn about them. Especially as regulators are flirting with giving the rest of us, not just the rich, access to hedge funds for the first time.

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Their wealth is not exaggerated. Just days ago, one hedgie calculated the final numbers on what might be history’s biggest pay cheque: funds run by John Paulson are up £6 billion after doing nicely from the global credit crisis, and his share is estimated at a billion pounds or so. Indeed, several got close to a billion a year ago. There was John Arnold, then 33, who correctly judged that natural gas prices would go down, not up. And the mathematician Jim Simons, 69, whose fees, at 44% of investors’ profits, mean that he, too, was near nine zeroes sterling. The oil speculator

T Boone Pickens, 79, took home half a billion. London’s big hitter is Noam Gottesman, 46, one of the three founders of GLG Partners, whose 2006 income is estimated at £225m. The year just ended will have been more rewarding for him, as a stake in GLG was floated on the New York stock exchange, giving him another half a billion. But all of this is misleading. Because, as with other sorts of people, hedgies seem not to fit the stereotype when you get up close. John Paulson, the name on 2007’s billion-pound cheque, has a quiet manner, sombre suits and understated offices, and he keeps his feet under the desk. So it is in London, too.

We are in the offices of a London hedgie who manages more than £2 billion. He is an intellectual with a commanding presence and no small talk. Subordinates move out of the way with the sort of submissive body language that reveals that however highly paid they are, they are not relaxed. In fact, this hedge fund, in a nondescript office block next to John Lewis, does not seem a particularly happy place.

Like all hedgies, this person is private. It’s partly the rules: they are afraid of talking to the public, in case what they say is construed as marketing. There can also be a fear of kidnap. But the hedgie is keen for you to understand his world. Even some people in the City, he says, do not comprehend what hedge funds do. Could you please explain short-selling to them? We’ll do our best. But first, what is a hedge fund?

There is no agreed definition, so let’s construct our own: a hedge fund is a pool of investors’ money with almost total freedom. Hedge-fund managers enjoy every toy in the money world’s box. They can sell things they do not even own. They can buy things of such complexity that nobody knows what they are really worth. Unlike the traditional funds that you might save in, some are willing to trade anything: carbon emissions, international freight prices, even the weather. And they are allowed to make trades in huge size, resulting in spectacular profits and losses. But the crucial difference from a conventional fund is this: they aim to make money all the time, and no excuses.

Regular fund managers think in relative terms: if the FTSE drops 50% but they lose just 30% of your savings, they have served you well. The hedgie mantra, by contrast, is “absolute return”. The phrase simply means profit. And they pay themselves well. Despite a dramatic growth in hedge-fund numbers, from 610 worldwide in 1990 to more than 10,000 in 2007, the fees have not gone down. The managers, who range from a majority of 100-hours-a-week number-crunchers to a minority of incompetent gamblers, take 2% of the money they manage as an annual fee, plus 20% or more of the profits. The best skim off half their investors’ returns. Clients pay because they know they are lucky to be included in the party: many top funds are closed to new investors, and if one client pulls his money out, another takes his place. The funds use the fees not only to reward themselves but to hire the best analysts, in an intellectual arms race.

It does not always work. Each year at least 1 in 20 hedge funds performs too poorly to survive. In the year just ended, the figure might be as high as 1 in 10. And then there are the characters.

Bertrand des Pallières, of the London hedge fund SPQR, was so busy trading debt he didn’t notice for three months that his £80,000 Maserati had been towed away. Andrew Tong, a junior hedge-fund trader in New York, claims he was encouraged by his boss to take oestrogen to calm his over-aggressive trading, with the result that he lost interest in his wife and began a gay relationship with his boss instead. Last September, Florian Homm, the 6ft 8in Majorca-based star of Absolute Capital Management, handed over 4m shares in his hedge fund as part of a divorce settlement, then resigned from the fund in an open letter that caused his newly ex-wife’s shares to fall in value by 85%. “Many [hedgies] are nuts,” one investor says. “But that’s what often comes with brilliance.”

Like many lucrative ideas, hedge funds were not invented for money. They were an academic concept. The first is credited to Alfred Winslow Jones, a journalist turned trader who ran his fund in almost total secrecy from 1949 to ’66, when a newspaper noticed that his profits exceeded even the most successful traditional funds. But he had at least two predecessors. We can name one: in 1930, Karl Karsten created a fund to test theories on economic forecasting. By June 3, 1931, the statistician’s money was up by the equivalent of 250% a year. The other pioneer, who is mentioned but not named in a 1930s economics book, is lost in the smog of time.

Karsten’s idea, which he called the “hedge principle”, was this. Suppose you think that one part of the economy will do better than the rest. You have no idea what will happen to the stock market overall, nor where the next political or financial crisis is coming from. All you know is that it is 1931 and you like the prospects for car makers. You could buy shares in car makers. But what happens if the second world war starts? Your shares might crash in price. Karsten’s answer was to carry out multiple transactions at once. You buy your shares in the car makers. But at the same time, you sell short an equal value of all the stocks in the market. (Sell short means to borrow something you do not own, and sell it. Of course, you have to buy it back later and return it to the owner.) This way, you are no longer betting that car companies go up in price. In fact, you don’t give a fig where the stock market goes. If it crashes you will still make money, provided car stocks fall less than the rest, because the profit from what you borrowed and sold is bigger than the losses on your car stocks.

And that’s short-selling. It’s not always a naked bet that a company’s share price is going down. It’s usually half of a two-part judgment. The view might be that cars are the future and railways in decline. Or that one firm is stronger than a rival. When the trades have run their course, the hedge fund reverses them: it sells what it bought, and buys back what it sold. In a modern fund it gets much more complex than that, but this is the notion at the heart of the hedgie world.

Not surprisingly, a true hedge fund can lag behind in very strong markets, because it is hedging its bets all the time. As the recent bull run in stocks got under way in 2003, hedgies advanced 19.6%, according to Hedge Fund Research of Chicago. But stocks jumped 28.7%, so you were better off without the hedgies’ costly expertise. This is exactly how it is meant to be: what hedgies try to offer is consistent returns. On a graph, the stock market will go up and down, but good hedge funds will keep moving up. From 2000-2, for example, hedgies went almost nowhere, achieving 8.2% in three years. It sounds like a dismal performance – until you consider that stocks halved in value.

“There are many ways that hedge funds are misunderstood and caricatured,” says our hedgie, a quietly intense figure in a white shirt and no tie, sitting in a room with white walls, no art and no distractions. “The most important is that hedge funds have this image of being risky.” And it is true. Few hedge funds blow up, even if their occasional, spectacular self-destructions get noticed. Instead, the weak ones underperform, investors withdraw cash, and they just go dark, like a theatre with bad reviews. Overall, they are a relatively safe place for investors’ cash, as long as you spread your money across them – as many pension funds have realised.

There are other surprises. Money is not the main motive. The reason our first witness created his fund should make sense to anyone who has been promoted away from the front line. “I thought trading the market was incredibly interesting,” he says. “But in a large bank, sooner or later you have to give up, because you get promoted and must run a department with lots of people. If you say yes, you stop doing what you’re good at. If you say no, you have a new boss who tells you what to do. There’s no solution other than to start your own business.”

This hedgie lives in London and has a summer home in France. He spends all his time thinking about companies, even in the shower.

What do you drive? “A scooter.” What do you drive in France? “Er, BMW.” Which turns out to be seven years old. And this man runs £2.5 billion. It is the first hint that, while some who work for banks and hedge funds may be Lamborghini-loud and brash, many managers tend to be private family men in their forties and fifties. If you look for a hedgie in Mayfair during half term, you won’t find one. They’re with their children on a beach, where, alas, they are not paying perfect attention. Hedgies are notorious for using BlackBerries to stay in touch with the markets. They might be physically present, but their spirits are in the stock exchange.

The second manager we meet is more colourful, in charge of £10 billion. This is a competitive business, he says: before we invest in a company, we meet its managers, rivals and suppliers, and even its shipping company to check that the original company is telling the truth. Indeed, hedgies can act like investigative journalists: some will hire private detectives on the other side of the world to check that a company’s assets are actually there. A person might think: shouldn’t all investment managers do this? Alas, they do not. But hedgies can afford to. And they have more at stake.

“My risk appetite is probably much lower than people would expect,” says this second witness, echoing the first, in another whitewashed office with no distractions. “One thing I have learnt is that rich people suffer more pain from losing money than pleasure from making it.” He follows this with a claim not to have lost a penny for any client. Then the chatty billionaire with two mobiles goes off to meet his daughter for lunch. His brown jumper goes badly with his grey jeans – you would never spare him a glance.These, then, are some of London’s hedgies.

There is Michael Hintze, who manages £3.5 billion. He’s worth less than a tenth of that – call it £275m – and until last year lived quietly with his family in Balham, one of London’s more modest postcodes, with his children at state schools. But then he outed himself as the source of a secret £2.5m loan to the Conservatives, made because he believes the country “needs a strong opposition”, and the rest of his story tumbled out. His grandparents lost everything fleeing the Russian revolution in 1917, and moved to China. His parents lost everything fleeing the Communists in China, and moved to Australia. Hintze has a background Tom Wolfe would recognise: he started on Wall Street at Salomon Brothers, among bond traders who saw themselves as “big swinging dicks”. Not in this case. Hintze has no yacht, mansion, private jet or classic-car collection. Instead, he has paid for the restoration of Michelangelo’s frescoes in the Pauline Chapel of the Vatican, and given millions to the Victoria and Albert Museum, to his old university in Sydney and to London theatres and a hospice. This puts him alongside Christopher Hohn of the Children’s Investment Fund, accounts for which show gifts of £1m a week to children’s charities in developing countries. Hohn will not talk about it. But colleagues say he transfers a fixed percentage of assets to charity to motivate his own performance. And then there are the machines.

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On the fifth floor of a 1970s building by the Tower of London is a bank of computers that look like fridges. Into these machines stream market data, tick by tick, pip by pip, and every now and again the fridges spit out an order. This is how history works: the building is Sugar Quay, once occupied by three brothers, ED & F Man, who made sugar barrels. They realised they could make more money from what went into the barrels, so they became sugar traders. Their successors realised that machines were better traders than people and got rid of the sugar traders. “The computer does it unemotionally and remorselessly, in a way no human ever could,” says Man Group’s Stanley Fink, who gave £4m to charity in November. “Because most human beings would think, this time it’s different.” The computers generate orders in every market you can think of, while outside sit PhDs in maths and statistics who keep the machines ahead of the markets.

I don’t know what is in their models, but I can guess. Since the dawn of trading, people have been predictable. Sometimes they are gripped with excitement – at how technology is going to transform our lives, say. Sometimes they are overwhelmed with pessimism – for example, that we are living on dodgy credit and the banks are in trouble. How human beings handle fear and greed does not change. People are usually right about what they see. But they get the timing wrong, and take too much risk backing their judgments. “Markets can remain irrational longer than you can remain solvent,” as John Maynard Keynes, the economist, said. What the PhDs do is to take advantage of humanity’s predictable mistakes. This, too, is a hedge fund.

Why do we think of hedgies as high risk if the opposite is true? It’s because of their freedom. A hedge fund can borrow against its assets, just as you use your house to buy a car. Except that hedgies may borrow many times over. It’s as if you used your house to buy the whole car factory. If the purchase then falls in value by just a few per cent, the house is repossessed.

The most famous example is when Long Term Capital Management (LTCM), with two Nobel prize winners on the payroll, threatened to take down the global financial system. Like many computer-driven trading strategies, LTCM’s trades had been tested using optimistic assumptions. It happens all the time: last year, even the usually invincible Goldman Sachs bizarrely blamed “25 standard deviation moves”, which roughly translates as an event last experienced by the Neanderthals, when three of its funds plunged 30% in a fortnight. But LTCM was much worse. It had bought the car factory: it had made investments of more than a trillion, even though its house was worth only a few billion, and the trades were going wrong.

Then there are the games they play on the international stage. Hedge funds played a role in the Asian economic crisis in 1997, when millions lost their jobs and some starved. Consider Hong Kong. To begin with, it fared better than its neighbours, but then the hedgies attacked Hong Kong in a daring act of aggression known as the double play. It was really a triple play: to force up interest rates, kill the local stock market and push the currency into freefall, all at once.

After agonising in secret for nearly two weeks, four top officials spent $15 billion of public funds defending the stock market. They also guaranteed the exchange rate for six months. The currency held. The story is financial James Bond.

Given such dubious practices, what do hedge funds add to the sum of human existence? More than you might think. The problem is that our perception comes from these morally reckless episodes. Today, however, it is wrong.

In the buccaneering days – in 1990, say – 71% of hedge-fund money was “global macro”. It made bets on everything from stocks to pork bellies. George Soros, who famously “broke” the Bank of England in 1992, would raise the size of his wagers until his back hurt. If the multi-billionaire’s body began to bother him, he knew a trade was no longer valid or the bet too large. It was Soros who forced the UK out of the European exchange-rate mechanism by selling more than $10 billion-worth of pounds. Yet only one in 10 hedgies today is a Soros wannabe: most are like the London hedgies we met earlier.

Secondly, there is always a reason. Hedge funds don’t agitate for change at a company, potentially putting you out of work, or attack a country, putting millions out of work, because they feel like it. They do it because the facts invite them in. Hong Kong had the highest land prices in the world. Southeast Asia was on a borrowing binge. Banks were making long-term loans on property by borrowing short-term from foreigners. It’s a version of Northern Rock. Human nature never changes: it finds new ways to make the same mistakes. And hedge funds are messengers. Their economic role is to point out errors and correct them. And that is good for us. Research by the Organisation for Economic Co-Operation and Development (OECD) has concluded that on balance, “activist” hedge funds help companies. In Britain, of course, Soros bequeathed us low interest rates and unprecedented prosperity.

One role of hedge funds is to be the buyers and sellers of strange and exotic contracts. Take the environment: we all hope carbon trading, in which dirty companies and countries are forced to buy carbon credits from clean ones, will provide an incentive for humanity to clean itself up. But new markets can function only if they’re liquid, meaning that there is a buyer when you need to sell, and a seller when you want to buy. Hedge funds are important sources of “liquidity”.

In future, hedgies will help us support the old, and not just by trying to improve pension-fund returns. One day there will be a futures market in life expectancy. If you are a pension fund, or an employer with too many pensioners and not enough workers, you will be able to protect yourself against the risk that people live longer – a serious problem for some companies – by buying futures contracts. If there is then a big medical breakthrough, and you are faced with paying pensions for an extra 20 years, you won’t have to impoverish your pensioners to make the money stretch the extra time. A person with two mobiles, in a brown jumper and grey jeans, will decide that you’re wrong about how long people are going to live, and will sell you a futures contract. Your life-expectancy risks are hedged.

You should know that I have an interest in this: I’m not as objective as when writing on other subjects. I own 50% of a hedge-fund management company, Merlin Capital Management. The company is a shell and it has no hedge funds yet; if there were, I couldn’t write this. Hedgies are not allowed to market themselves. The marketing restrictions, to deter hedge funds from selling to people who do not understand them, are probably wise. There will always be cases such as Brian Hunter, head energy trader of Amaranth Advisors, who lost

£3 billion in two weeks by betting the house on natural gas. But there is no good reason why ordinary savers should not have access to the big hedge-fund groups. Whisper this, because the fact is rather boring. Hedge funds have grown up. Most are low risk. In the credit crisis it was banks, not hedge funds, that got us into trouble. The real cause for discontent lies elsewhere. Two months ago, the Money section of this newspaper carried some front-page advice: “Quit shares for cash, investors told.” Morgan Stanley, the investment bank that predicted the credit crisis last June and the market bounce in August – not difficult if you are an investment bank – “is recommending clients bank their profits from equities, and shelter in cash ahead of the downturn”. History shows it was honest advice.

But why should all the little people have to get out of markets just because they are heading down? Is our role really to buy, buy, buy on the way up, and then to sit quietly until someone is kind enough to say that it is time to buy again (a message that usually emerges after the oracle has done his own buying, of course)? Some hedgies, by the way, are using derivatives to bet that the value of your house will fall 10% this year. Is it not a bit rich that they can profit from your house declining in value – but you cannot put any money into them? If there is anything morally offensive about hedge funds, it is this: some of the prosperity they create for themselves and for their investors is a straight transfer of wealth from ordinary people, whose money managers are not allowed to do the things hedge funds do. But it is not the hedgies’ fault.

In one respect, Alistair Darling’s pre-Budget report was even more inept than it looked. An unintended consequence has been to set back the day when you can save in hedge funds. The Financial Services Authority (FSA) had noticed that private investors were getting access to hedgies randomly, without much guidance or advice. It decided to allow authorised funds of hedge funds – actually called Faifs, or funds of alternative investment funds – from this year. This was beautifully timed. You would have been able to decide that as the economy looks bleak, you’d save with hedgies instead.

But the pre-Budget report cut capital gains tax to 18%, creating a huge incentive for savers to stay in inflexible investments, just as the markets started turning down. (Hedge funds attract income tax, not capital gains tax.) Darling has killed the FSA’s plans for the time being.

Some people are already saving in hedge funds by investing overseas, or by buying one of the entities created by hedgies to allow UK investors access. But these entities are a bit complicated for your average financial adviser, and to most people the funds remain a mystery.

Yet they are part of economic life, and overall, they’re probably a force for good – even without the philanthropy. George Soros has been giving away money since 1979, when he began providing funds to help black students attend the University of Cape Town in apartheid South Africa. Today his foundations spend £200m a year. Call this narcissistic if you want, but when it comes to the death bed, I can think of better reasons for self-reproach than being a hedgie.

In the lion's den

Randall Dillard, one of the UK’s most successful hedge-fund managers, shares his secrets

We wanted to photograph Randall Dillard at his office in an 18th-century town house in Soho. Behind the Matisse art works on his walls is an air-filtration system that cleans London’s air to heart-surgery standards. But it was three days before Christmas: he was on the private Caribbean island of Mustique.

Dillard is the top hedgie at Liongate Capital Management, which invests in other hedge-fund managers. First he takes a view of the world, then he and two partners scrutinise 10,000 hedge funds until they have 30-40 managers they are happy with, before divvying up the £900m that Liongate manages. Liongate analyses individual hedge funds in a process that sees money being given to some, and taken away from others, all the time.

A year ago, for example, Dillard decided that the credit markets, which include American sub-prime mortgages, were a disaster waiting to happen. So he looked for hedge funds that would make money if credit got into trouble. He likes managers who are at an early stage in their careers — his research suggests that after three years a hedge fund has peaked. And it is important that his 30-40 managers work in different ways: if a bet goes wrong for one fund, the others should be unaffected.

On his return from holiday, Dillard is looking for managers who will profit from the recovery when the credit crisis has run its course. There is a lot of statistical analysis involved in choosing managers, but painstaking, passionately argued selection ensures Liongate returns 18% a year for its investors.

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