HOW THE RICH GET RICHER
By Shelley Neumeier

(FORTUNE Magazine) – Mark Strome is having a great year. The swashbuckling Los Angeles investor shorted government bonds in the U.S. and bought them in Europe and Japan. He traded currencies and played the international stock markets. His maneuverings with a $700 million portfolio will earn Strome, 37, and his colleagues close to $150 million this year. The investors in his partnership will walk away with more than 100% on their money. How can you get a piece of his investing skill? It's all yours -- if you've got at least five million dollars you'll let him play with. Strome manages a hedge fund, one of an estimated 700 such limited partnerships in the U.S. Despite their name, hedges can be plenty risky. Some don't even use hedging strategies. They typically require investors to ante up $250,000 to $5 million. To escape stringent regulation, by Securities and Exchange Commission mandate they may have no more than 99 partners. As those slots fill up, managers often raise the minimum investment to make sure they sell each increasingly precious place to the highest bidder. Those with the price of admission often get a big payoff. E. Lee Hennessee, a consultant at Smith Barney Shearson in New York City, says a group of 100 hedge funds she tracks returned 19% from January through September. That's five percentage points more than the average equity mutual fund. Hedge funds keep their edge over time: Donald J. Hardy, head of private investment services at Frank Russell Co. in Tacoma says as a group they have done five percentage points better annually than the S&P 500 over the past three years. Since most money managers underperform the market, what's the secret? Hedge funds are like exclusive casinos where both the players and the house can win big. The managing partners typically take 20% of the profits, in addition to a 1% management fee. (By contrast, the law forbids mutual fund managers to take incentive fees.) A manager of a $30 million portfolio who musters a 25% annual return walks away with more than $1.5 million. That gives smart money managers a big fat reason to leave those $200,000-a-year jobs at Fidelity and start their own partnerships. Most managers also invest a large part of their own net worth in their funds. The structure of a hedge fund -- or the lack of it -- lets the smartest managers shine. Because the partnerships are loosely regulated, they can invest in just about anything and leverage their funds to the moon. Lately, ''macro'' funds like Strome's and those run by celebrity investor George Soros, which bet on vast international economic movements, have been the biggest winners. Hennessee's index shows them returning an average of 46%, before fees, so far this year. Many of the other top performers over the past three years got there simply because good stock pickers run them. Since their managers can short stocks, unlike most of their mutual fund counterparts, they can make money when a situation sours instead of merely liquidating a position to stanch losses. Jim Harpel, 55, a veteran manager who holds a hot hand right now, has racked up well over a 50% gain so far this year in part by shorting some of the market's biggest losers -- Apple Computer, Kellogg, Merck, and U.S. Surgical. The ability to take concentrated positions gives smart stock pickers who run hedge funds an added advantage. Cappy McGarr, 42, head of McGarr Partners in Dallas, has his $45 million portfolio invested in only 15 securities. Over 20% is in Vodafone Group, a British cellular company he thinks is cheap. The stock traded recently as an ADR for $81. If it climbs to over $110, as he expects, the whole portfolio will get a big lift. Some funds devote all their attention to a single kind of trade or security. Among the ones that are hot and getting hotter are those concentrating on risk arbitrage. Richard Nye, 53, a principal at Baker Nye in New York City, which has specialized in risk arbitrage since 1967, profits by playing off the differential in stock prices when two companies announce a merger. Using leverage, he expects to make annualized returns of 20% on some trades -- with relatively low risk. Of course, there's nothing inherently lucrative or even safe about a hedge fund. Terrific gains can be offset by tremendous losses. Funds that only short stocks, for example, lost an average of 10.5% annually over the past three years, according to Frank Russell Co. Even heavyweights like Essex Performance LP and Julian Robertson's Tiger Management LP have fallen as much as 20% to 30% in a single quarter. Still, William Lowery, a principal at Performance Analytics in Chicago, predicts that as the markets become rougher, more people will be willing to take big risks to make juicy returns. He says institutions will increasingly opt for these alternative strategies to meet the performance requirements of pension funds if stocks sag. Couple that kind of demand with the huge financial incentive managers have to start them, and chances are you'll see hedge funds continue to proliferate.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: PERFORMANCE ANALYTICS CAPTION: A HANDFUL OF HIGH-ROLLING HEDGES