The New Masters of the Universe

Markets climb, markets dive, and it all seems to involve fast talk and sleight of hand, as well as computers and high-level math. Indeed, a lot of smart people think it’s not wise or even possible to try to beat the market—the long-popular “random walk” theory concludes that over time you just can’t win.

But the guys who manage hedge funds believe you can.

The lords of these investment companies take on a small number of big-time investors, and use a variety of aggressive and often mysterious strategies to make often astounding amounts of money for their clients, and for themselves. But they’ve also lost billions.

While there’s no single definition of a hedge fund, financial journalist Sebastian Mallaby pinpoints four characteristics in his new book More Money Than God. The funds’ managers avoid publicity and regulation so they have flexibility to shift strategies. They embrace short selling—that is, trades that bet the price of a security or commodity will go down—so that they can make money when other investors are losing. They rely on a lot of borrowed money, called leverage, to magnify their bets. And they are paid on performance, as well as a percentage of assets—usually a stunning 20 percent of the profit they make for customers.

Mallaby, a fellow at the Council on Foreign Relations and a columnist for the Washington Post, takes a personality-driven approach to showing how hedge fund managers move and shake in a world of stock, bond and currency speculation that is nearly impossible to explain to the uninitiated. Mallaby keeps his topic human by focusing on the individual masterminds. Greed and risk are always with us, he writes. Still, he concludes, hedge fund managers are, on balance, the good guys.

Mallaby recently spoke with the AARP Bulletin about hedge funds and the people who run them.

Q. The thing that drives people absolutely nuts about hedge fund managers is in the title of your book: They have more money than God. How can these compensation structures possibly be fair?

A. In some ways they are a lot fairer than the smaller fees charged by mutual fund managers. That sounds preposterous, so let me explain. When you pay an actively managed mutual fund that’s trying to beat the market average, every study that’s been done by academics shows that, on average, mutual funds don’t beat the market average. With hedge funds, the best academic studies show that they do provide positive value. Now if as a society we think that what’s left over for the hedge fund managers is socially unacceptable, the answer is to tax them more. I don’t think that their clients are being ripped off, unlike with many financial products.

Q. You point out that about 5,000 hedge funds failed between 2000 and 2009. Are those investors being ripped off?

A. There are hedge funds that go wrong and lose money. It’s important, though, to remember that the risk actually is not bigger than lots of things that people do in finance every day.