http://www.nytimes.com/2005/05/22/business/yourmoney/22money.html By NINA MUNK Published: May 22, 2005 HEDGE fund managers once had nerves of steel. In the 1980's and 1990's, men like George Soros, Julian H. Robertson Jr. and Michael H. Steinhardt made huge, daring bets on foreign currencies and on interest rate spreads. Secretive, and unsupervised by the Securities and Exchange Commission, hedge fund managers were figures of awe. In the words of a 1994 Business Week article, they were a "widely feared Wall Street subculture." For years, this feared subculture made millions for its investors. For example, between its inception in 1967 and its dissolution in 1995, Mr. Steinhardt's hedge fund grew at a compound rate of 24 percent a year, after fees - more than twice the compound annual growth rate of the Standard & Poor's 500-stock index (with dividends reinvested). In other words, $10,000 invested with Mr. Steinhardt over that span would have swelled to almost $5 million. Hedge funds didn't always grow in a straight line, of course. In 1992, Mr. Soros made $1 billion by betting against the British pound. Two years later, trading in Japan, he lost $600 million - in a single day. Then there was Long-Term Capital Management: in August 1998, using $30 of leverage for every $1 of capital, it lost $1.9 billion and nearly brought down the world's financial markets. Back then, hedge fund territory was the Wild West of international finance. "In a certain sense, it was the last bastion of nearly pure capitalism," Mr. Steinhardt said when we spoke last week. "It was a gunslingers' world and we were the gunslingers." These days, though, you won't find many gunslingers in the industry. Instead, hedge fund managers are now content to beat the S.& P. 500 by a mere percentage point or two. Last month, the Hennessee Hedge Fund Index, which tracks about 900 hedge funds, was down 1.8 percent after fees; the figure is more or less in line with the 1.9 percent drop in the S.& P. 500. In 2004, the average hedge fund actually underperformed the market: with the S.& P. 500 up 10.9 percent, the Hennessee Hedge Fund Index gained only 8.3 percent. Historically, the whole point of a hedge fund was to outsmart the market. Because their clients were rich and sophisticated, hedge funds were allowed to gamble with investors' money. Unlike mutual funds, which are strictly regulated under the Investment Company Act of 1940, hedge funds could take risks: they could buy stock options, use leverage and bet against stocks by selling short. As conceived in 1949 by Alfred Winslow Jones, then an editor at Fortune magazine, a hedge fund hedged its bets by taking "long" positions on undervalued stock and "short" positions on overvalued stocks. The idea was to be smart and nimble and bold, and to make oversized returns. As Mr. Steinhardt said, "I only had one objective: to have the best performance in America." In the last decade, however, hedge fund companies have started to resemble mutual fund companies: big, plodding institutions for pensioners. Fewer and fewer hedge funds are now making impressive returns for their investors. In the 10 years through April 2005, according to the HFRI Fund Weighted Composite Index, the typical hedge fund has only just managed to beat the S.& P. 500 Index, with an average annual return of 11.97 percent compared with 10.26 percent for the S.& P. 500. In other words, the Wild West has become a suburban community, where managers ride golf carts instead of bucking broncos. What happened? For one thing, the amount of money invested in hedge funds has doubled in the last five years, to $1 trillion. It's hard to find creative places to park that much money. Besides, no special skills are needed to create a hedge fund - that's why everyone and his uncle know somebody who's starting one. Investors are partly to blame. They love the glamour of investing in hedge funds, but, at the same time, they can't tolerate risk. Most investors can't tolerate even a month of losses. The real problem with hedge funds may be the managers themselves: they're earning too much money. It's almost vulgar. In the past, hedge funds were paid 1 percent of assets under management, plus 20 percent of that year's return. Recently, even as their performance has sagged, more and more hedge funds have increased their fees to 2 percent of assets under management - plus 20 percent of returns. To make big money for themselves, hedge fund managers don't have to make big returns; they just need to hold on to their pool of clients. Rumor has it that chief executives are overpaid in America. Compared with the hedge fund managers, the C.E.O.'s may have a bad deal. ON average, according to Institutional Investor's most recent survey, the 25 best-paid hedge fund managers each took home $207 million in 2003, about double what they made a year earlier. That's $207 million in cash - not in equity or stock options. Meanwhile, the nation's 25 highest-paid chief executives each made an average of $37 million in total compensation last year, including options granted (but not those exercised), according to Business Week. Most hedge fund managers do make money for their investors. But even if a hedge fund manager doesn't make a cent for his investors, the manager invariably makes a fortune for himself. Think about it: just for showing up to work, the manager of a hedge fund with $1 billion in assets is guaranteed to earn $20 million a year in management fees alone. Why should he take any risks? Why should he alienate his cautious investors? If we add in his 20 percent cut of the gains, and assume that his returns last year were just average (in line with the S.& P. 500) he would have grossed a total of $41.8 million. Let's say that our hedge fund manager's office costs him $15 million a year. Bottom line: having done nothing exceptional, he would have pocketed a cool $26.8 million after expenses. Can you think of another business that works like that? Nina Munk is a contributing editor for Vanity Fair.