In this extract from his new book, The Game, Alex Buchanan explains how hedge funds became the best gig in town

IN THE 1960S if you were young, talented and British you went to work for the BBC or the Foreign Office. In the 1980s you dreamed of being in advertising or investment banking. In the 2000s there was only one game in town – you became a hedge fund manager.

Once upon a time the institutional investment world was a cottage industry and stock markets were ruled by pension fund managers, insurance companies and banks. Neither glamorous nor flashy, they managed your money to differing degrees of success, parcelling your money into the various asset classes (mainly equities, bonds and cash) and charging a fee for doing so (in the region of 0.5 to 1 per cent per annum). The authorities regulated them and smacked them on the wrist whenever they tried anything adventurous. It wasn’t exactly thrilling but no one complained – it worked.

But an investor with ability or ambition soon became frustrated. Restricted as to what he could invest in, bound in red tape and badly paid by the standards of brokers, he began to look for ways to spread his wings.

Hedge funds have been around since the 1960s and in some guises even earlier, but the industry only began to take off towards the end of the 1990s as an increasing number of people bought into the fantasy that hedge funds, whatever the economic conditions or market gyrations, always made money. 2002 was the defining year. Stock markets, rocked by 9/11 and fearful of a worldwide meltdown, collapsed but the hedge fund industry returned an average of 6 per cent.

Now the genie was out of the bottle. Money began to flood into the industry, dragging with it an ever-increasing number of entrepreneurs, gluttons and chancers. Suddenly, anyone thought they could run a hedge fund. All you needed was a desk, a computer screen and a West End address.

What on earth was going on? Hedge funds blew traditional fee structures sky high. Many worked on a ‘two and 20’ model (and indeed many still do), charging the investor a 2 per cent annual management fee and taking 20 per cent of any profits (in the form of a performance fee). By way of example, if a hedge fund managed (or ‘ran’) £500 million and made a 10 per cent return on this money, its owners would charge a management fee of £10 million and would split the profits of £50 million between the investors/clients (who received £40 million) and themselves (who received £10 million).

In other words, hedge fund managers were using other people’s money to enrich themselves beyond their wildest dreams. If they lost money it wasn’t their problem – in most cases it wasn’t theirs to start with. The only risk they ran was reputational.

Whichever way you look at it, it was the most brilliant get-rich-quick scheme.

In 2003 to 2007 if you put up your hand and said, ‘I’m a hedge fund manager,’ you got two and 20, it was as simple as that. It was irrelevant whether or not you were worth it or even whether you had ever managed money before – people were too frightened of missing out on the next big thing.

The fun didn’t stop there. Like private equity firms, hedge funds were able to use their assets as collateral and borrow money from investment banks, thereby increasing the amount of money they were able to invest (and therefore the profits they were able to make) by a multiple of the original amount. Some borrowed as much as six or seven times their original equity as banks fell over themselves to lend the money.

No one stopped to consider whether a model that was, in theory, designed to align the interests of fund managers and their providers of capital was in reality encouraging excessive risk taking.

They were all too busy getting seriously rich. Hedge funds had bucked the market trend in 2002 for the following reasons. Traditional fund managers ran ‘long-only, relative return’ money and their portfolios tended to follow the vagaries of the market.

Hedge funds, however, rewrote the rulebooks. They offered “absolute return”. Largely unrestricted as to what they could invest in, they were able to operate with the kind of regulatory abandon a pension fund manager could only dream of. Not only could they ‘go short’ (ie, bet that an asset price would fall), they also had far greater access to derivatives. In 2002, while traditional managers were clinging on for dear life, content to lose money as long as they outperformed the benchmark, hedge funds were making hay from the mayhem. The world could not help but sit up and take notice.

And so dawned a new age of arrogance. The old buy-side guard were elbowed to one side as investment banks thronged to honour the new paymasters. Hedge funds traded more regularly, more exotically and with greater intensity than the pension funds ever had. In a world awash with cheap money their tentacles spread everywhere. Tie-less, ruthless and unyielding, they overturned the old orthodoxies.

But for all the charity dinners, private jets and changing of the social guard, rumblings of disquiet began to be heard.

In a world of spiralling prices and closely monitored performance metrics, investors piled more and more risk onto the table, paying top dollar for assets that they couldn’t sell when the tide came in and encouraging companies to load up with debt and hand back the cash to them, the shareholders. Before too long the hedge fund industry found that it too was victim to that economic maxim, the law of diminishing returns. By 2007 the average hedge fund manager was performing no better than his long-only counterpart. The problem was that he was charging much higher fees.

Critics soon cottoned on to another crack in the edifice. As markets headed north in 2003 to 2007, many hedge funds did no more than replicate the investment strategies of their long-only brethren. When the credit crunch arrived most just weren’t ready for it.

The following year was cataclysmic for the industry. It may have out-performed the wider market, but in 2008 the average hedge fund returned minus 19 per cent. The spell was broken. Cash-strapped banks pulled away the rug, demanding back the money they’d lent as hedge funds, already reeling from poor performance and anticipating large-scale client withdrawals, were forced to liquidate whole portfolios.

Those who’d locked client money in for the long term watched on as others, regardless of performance, drowned in the quicksand.

So, what happens next? Money is already returning, albeit in dribs and drabs, and despite the fact that politicians across the world are under pressure to derail the gravy train, on both sides of the political divide they can’t afford to bite the hand that feeds them – the shareholder will always rank higher than the taxpayer. Witness the recapitalisation of the UK banking system.

What is clear, however, is that hedge funds are under scrutiny like never before. Fees are already being trimmed – 2009 saw new hedge funds propose management fees as low as 0.75 per cent.

If we can say anything for certain it is this: some very self-important people are now being forced to consider other forms of employment. The age of the mediocre millionaire is over (for now).