The hedge fund high rollers risk all as the wheel spins

There are few more exotic ways to spend an evening than a soirée at the Casino de Liban. They were seeking finance from a group of London investors; we were on a less- than-conventional site visit. Standing at an open door, I peered through the dense smoke into the high rollers' room, where the concentration was intense.

There are few more exotic ways to spend an evening than a soirée at the Casino de Liban. They were seeking finance from a group of London investors; we were on a less- than-conventional site visit. Standing at an open door, I peered through the dense smoke into the high rollers' room, where the concentration was intense. One of our party had snuck in there to take on a man in a houndstooth suit puffing on a cigarette-holder. Our own young man wore a suit cut from velvet (hardly appropriate for the Lebanese climate). "Who is he?" I asked. My companion turned to me and hissed in hushed tones, "That's a hedge fund manager."

That was the first time I heard the term. Since then, hedge fund managers have come a long way. Having first acquired public prominence with George Soros's successful assault on sterling in 1992, they've gone on to create diplomatic incidents, as in 1998 when Asian governments talked of making them outlaws. They have ended up by attracting serious amounts of investment capital.

The industry is worth $500bn (£350bn) in the US, and it is now penetrating the mainstream of UK investing. Hedge funds are where it's at. But what are they exactly? There are more than 5,000 different ones in the US and probably twice that number worldwide. By their very nature they are dominated by high-calibre individuals following investment strategies peculiar to them. Nevertheless, you can group hedge funds into some broadly defined categories.

"Macro players" (such as Soros) speculate on big economic or political events, while "arbs" (arbitrageurs) exploit pricing anomalies between convertibles and equities or in merger situations. Otherwise, two traits are overwhelming: a tendency to gear up on your bet, and the ability to go short (ie sell something you don't own). One other common characteristic is the healthy profit that individuals running these funds make. Fees are normally 20 per cent of the upside return. If you get it right, then that's an awful lot of money compared to conventional fund management fees. This is why so many are leaving to set up their own operations.

It is this characteristic, combined with the gearing-up effect (sometimes to a scale of 100 times the value of assets managed), that makes this elite group the high rollers of the market. Inevitably, sometimes it can go wrong, and when it does many are left with burnt fingers. The arbs lost a cool $500m when an unexpected referral led to the ending of the Honeywell/ GEC merger. And the highly geared Long Term Capital Management was invested in by the cream of Wall Street; its demise threatened the whole banking system.

Because of the colourful characters involved, there is another way in which things can go wrong – which brings us to Herr Berger. This 29-year-old Austrian is currently standing trial in a Manhattan court accused of receiving $575m from investors, which then disappeared in the "tech wreck". He is accused of doctoring statements to prevent investors from realising the level of risk they were taking.

It is no wonder that the regulators are starting to take an interest. After the fall of LTCM there were some attempts to limit any potential future contagion to the banking system. But as an industry, hedge fund management remains remarkably unregulated. Paul Royce, director of the US Securities and Exchange Commission's investment division, has gone on record pointing to the dangers of this current boom. In particular, he points to those who recommend hedge funds to investors while earning commission from servicing the same hedge funds. He also highlights the brokerage firms who sell interest in hedge funds that are substantial customers of the firms themselves.

All this is not to deny the genuine role hedge funds can and will play for serious professional investors. They are particularly attractive at this time of bear markets, where the ability to go short (and get it right) can lead to positive absolute returns. A lot needs to be put in place, but if we can have greater disclosure, proper benchmarks and an improved regulatory regime, then a small percentage of professional investors' assets can sensibly be invested. But all these one-man bands of high rollers make me worried. They belong in the casino.