(Hartford Courant: Ritu Kalra, Courant Staff Writer) When two financiers hung out a shingle and called themselves Fairfield Partners in Greenwich four decades ago, they were pioneers able to run the state’s first hedge fund in relative obscurity.

Today, Fairfield County is peppered with hedge funds – largely unregulated investment companies that cater to sophisticated investors and move tens of billions daily in every financial market imaginable around the world.

In a single sweep, the group can disrupt the economies of entire countries. Their combined financial might causes prime ministers and presidents to tremble. Proponents claim they inject efficiency into the financial markets. Critics say they are the railroad barons of the 21st century, enmeshed in scandals and extracting fabulous wealth simply by moving money around. And Greenwich is quickly becoming the industry’s capital.

Of the estimated $1.3 trillion now managed by hedge funds, more than $100 billion is handled out of offices in Greenwich and neighboring towns, according to HedgeCo.net, a Web-based consulting firm. The company estimates that no fewer than 380 hedge funds now call Connecticut home, almost quadruple the number from a decade ago.

The future promises explosive growth. With it comes both risk and opportunity for the increasing number of average workers exposed to the industry, and for the local communities that have come to depend on hedge funds to support their economies.

By many estimates, hedge fund assets will double in size, to $2 trillion, by 2010, approaching one-quarter of the total assets that the mutual fund industry manages today. Much of that growth will come not from the wealthy individuals and university endowments that have formed the industry’s traditional investor base, but from retirement money socked away in pension funds looking for meatier returns.

The funds themselves are growing wings. They have driven the already gaudy Greenwich commercial real estate market to exorbitant heights. They are fanning out into the rest of Fairfield County. Other bedroom communities, such as Westport, Darien and the Rowayton section of Norwalk, have become hotbeds of hedge fund activity in their own right. Companies that support the industry – human resources outsourcing, back office trade processing, legal consulting – have sprouted around them, as has a new association.

The Connecticut Hedge Fund Association’s launch party in Greenwich this July was as oversubscribed as a hot initial public offering, with an exclusive by-invitation-only guest list of 150, and more than 60 people turned away at the doors.

“What Sonoma is to wine-making, Greenwich is to hedge funds,” said Stephen McMenamin, executive director of the Greenwich Roundtable, a nonprofit research organization that focuses on alternative investments, and managing partner at hedge fund marketer Indian Harbor LLC.

That’s certainly true for production. Research firm Greenwich Associates estimates that hedge funds comprised 82 percent of trading volume in U.S. distressed debt last year, half of all listed options contracts, and 30 percent of junk bonds.

Yet unlike the open meadows of California vineyards, hedge funds are shrouded in secrecy, leading to considerable consternation among regulators and investor groups. Their trading activity translates not only into a significant share of the profits that Wall Street brokerage houses make, but a disconcerting proportion of their credit exposure, as well.

Double-Edged Sword

The unregulated pools of capital have also lent themselves to cases of fraud. During the past five years, the Securities and Exchange Commission has identified 51 cases in which it said hedge funds cheated investors out of more than $1.1 billion.

The saga unfolding at Bayou Management LLC serves as a textbook example. The Stamford firm said it had assets of $440 million earlier this year. In July, the fund abruptly closed. On Thursday, two of the fund’s top executives pleaded guilty to running a massive fraud.

Among those whose money evaporated with the fund is the Jewish Federation of Metropolitan Chicago, a nonprofit that had more than $4 million invested in Bayou.

“Hedge funds fit the bill for sophisticated investors. You worry if you get small investors in hedge funds not understanding the rules. I worry a lot about that,” said Richard Marston, a finance professor at the University of Pennsylvania’s Wharton School.

Connecticut officials have said they will form a task force to look into reforming the industry.

“Bayou is like a single hair on a dog, not even a tail, in terms of the amounts of money involved. But the problems cannot be dismissed or ignored,” said Attorney General Richard Blumenthal, especially, he said, given the fact that the industry’s growth is now being fueled by philanthropic foundations such as the Jewish Federation, and by pension funds investing on behalf of ordinary workers.

“Every time people are scammed in a hedge fund, every dollar is critical,” Blumenthal said. “It matters to their retirements, to their health care, to their families, and that’s the reason we are looking so closely and intensely at potential oversight.”

To improve industry disclosure, the SEC will require hedge funds with more than $25 million in assets to register with the commission, beginning in February 2006. For the funds not already registered (about 40 percent are), registration will entail adopting basic compliance controls and opening themselves up to periodic audits.

Hedge fund professionals are of two minds about the increased scrutiny.

“It’s an interesting time. You have a lot of people who set up shop because they wanted to be under the radar screen, they didn’t want to be at a big firm anymore and they wanted to manage money in a stealthy manner,” said Bruce McGuire, president of the Connecticut Hedge Fund Association and founder of Blue Point Partners, a hedge fund marketing firm.

“But with all the institutional capital coming in, people are torn. They liked their old life. `I don’t want to register with the SEC, I don’t want people to know how much money I make. But do I want to get big?’ ” McGuire said.

Safety In Diversity

Some worry that the industry is already too big. And with Fairfield County playing host to some of the huge names in the field, a calamity in the hedge fund world could have grave consequences for local economies.

“If for some reason there’s an enormous shakeout in the hedge fund industry, Greenwich will get hit hard,” said John Goodkind, managing principal of Newmark of Connecticut, a Greenwich commercial real estate firm.

Yet Goodkind isn’t worried.

“Hedge fund businesses comprise many different lines of investments, so you’re not exposed too much to any one thing. It’s a one-industry town, but not a one-industry business,” Goodkind said.

Case in point: this past May, when the market didn’t blow up even though an everyday trade turned into disaster.

Many hedge funds had loaded up – with borrowed money – on General Motors’ bonds and shorted, or bet against, its stock on the anticipation that the automaker’s financial woes would dampen its share price even while the company continued to make interest payments on its debt.

Then financier Kirk Kerkorian bid for a 9 percent stake in GM, one day before its debt was downgraded to “junk” status. The upshot: GM’s stock skyrocketed while its bonds tanked. And the “hedged” trade blew up.

Investors feared the worst, quickly spinning rumors about the fallout. Indeed, for funds making large bets based on prices they expect to move in parallel, even minor curves can spell trouble. But the turbulence never turned to crisis, in part because hedge funds today employ such a variety of strategies that a bump in the road for one does not mean disaster for all.

A Chastened Industry

Fund managers appear to have learned a few lessons from Long-Term Capital Management, the infamous hedge fund that imploded in 1998 and nearly took some of the largest banks on Wall Street with it. Conversations with some of today’s managers reveal anything but a cavalier attitude toward risk.

His lobby is full of fresh flowers and photographs of glorious mountain peaks and the Connecticut countryside. But just beyond the receptionist’s desk, the office walls confirm his words: 15,000 square feet of light-filled rooms in the heart of Stamford are lined with charts graphing probabilities, tracing worst-case scenarios and measuring exposure to markets around the world. Analysts stare intently at the jagged red lines, trying to pluck opportunity from the graphs on the walls.

At any given moment, Saunders has his finger on perhaps the most important measure of risk: In the face of a complete market collapse, he estimates that less than 6 percent of his $3 billion fund would wipe out.

“I’ve seen risk. I know I want to be able to measure it. And I want to know how much I can lose. I can sleep at night,” he said, a sheepish smile spreading across his face.

Still, even he acknowledges that critics have reason for concern: Contrary to their name, not all hedge funds “hedge” their trades – which means some investors are paying exorbitant fees simply to take the same risks as an index fund.

Land Of Plenty

For fund managers, the rewards can be rich. Greenwich-based Edward S. Lambert raked in a tidy $1 billion last year, according to Institutional Investor magazine’s list of the 25 highest hedge fund earners. Four of the top 10 are based in Greenwich; the lowest among them made $225 million in 2004.

The wealth has also spilled over into the local economy: Between 20 and 30 percent of the 5 million square feet of office space in Greenwich is now occupied by hedge funds, and another 30 percent is taken by the financial services firms that support them.

“I would say 75 to 80 percent of the deals done in the last five years have been hedge fund-related. That might even be conservative,” Newmark’s Goodkind said.

Real estate prices reflect the industry’s influence. Office space in Greenwich can fetch between $60 and $70 a square foot – with $100 not an unheard-of figure. That compares with the high $20s for comparable office space in neighboring Westchester County, and the mid-$50s in midtown Manhattan.

“The industry has single-handedly driven the market. I have never seen office space go up that much in any other period. Even in Manhattan, it hasn’t grown that dramatically,” Goodkind said.

Local charities also report getting a lift from the generosity of fund managers. Gerald Nielsen Jr., on the board of the Darien United Way, said fund managers easily drop $10,000 each in donations to the local organization. Recently, Nielsen was on a committee to raise money to refurbish a football field in town. It took him less than two months and a handful of e-mails to raise $1 million from local hedge fund managers.

Fairfield County’s draw: no daily commute, proximity to New York City, green grass, fresh air and freedom from terrorist threats. Indian Harbor’s McMenamin fled Manhattan after the 1993 World Trade Center bombing.

“It took us four hours to get out of the World Trade Center and walk down from the 104th floor. That was a warning shot,” he said. “When September 11th happened, managers who already lived here in Fairfield County realized they didn’t have to go into New York City every day, with its large bull’s-eye.”

To an industry driven by numbers, the state’s tax savings can hardly be overlooked. Fund managers living and working in Manhattan pay as much as 11.34 percent in state and local income taxes, compared with 5 percent in Connecticut. That six-point spread translates into more than $120,000 in annual savings for the average fund manager making $2 million a year.

Connecticut has also minted money from the growth. Because most hedge funds are set up as partnerships, personal income rather than corporate earnings are what count for taxes. The top five hedge fund earners in Fairfield County made a total of $2.1 billion last year, according to Institutional Investor’s rankings.

For the state, that translates into more than $100 million in income taxes from five people alone – enough to fund Connecticut’s investmentin stem cell research for the next decade.

“You know, the contributions made by some of the individuals or companies in this industry have been enormous. They have tremendously enhanced the fabric of our community, not just in one town but throughout the area and even the state,” said Blumenthal, who lives in Greenwich. “I would resist any regulation that would inhibit their coming here, let alone cause them to leave.”

By the looks of it, hedge funds are as fond of Connecticut as state officials are of them. One year after Long-Term Capital imploded, its legendary founder, John W. Meriwether, quietly opened up shop again, starting JWM Partners with about $500 million of investor money – in Greenwich.

One of Meriwether’s supporters during the Long-Term Capital crisis, Citigroup Chairman Sanford Weill – also a Greenwich resident – announced in July that he would step down next year, most likely to start his own hedge fund.

It’s a testament to the industry’s ability to continually reinventitself, and Wall Street with it.”Hedge funds 20 years ago were toddlers. Then 10 years ago they becamegangly teenagers. Now we’re out of college. What do you do? You get awife, and she tells you where she wants to live. Guess what? It’sFairfield County,” said James F. Tomeo, chief operating officer of SSARIS Advisors LLC, a subsidiary of State Street Global Advisors thatruns a $3 billion hedge fund.Said Tomeo: “We’re ready to settle down. And we’d like to stay.”

A discussion of this story with Courant Staff Writer Ritu Kalra is scheduled to be shown on New England Cable News each hour Monday between 9 a.m. and noon.

Copyright 2005, Hartford Courant