(FORTUNE Magazine) – It's 9:30 P.M. and Leon Cooperman, manager of the $4 billion hedge fund Omega, is in the middle of a long day. On one line he's got a young Wall Street whiz--call him John--who wants advice because he wants to break into hedge funds. Cooperman's first question: "Are you a rocket scientist or just a smart kid?" John, who's a research analyst at a top brokerage, doesn't hesitate. "I'm a rocket scientist," he says. Barks Cooperman: "Why do you want to work at a hedge fund?" "Because," John replies, "that's where all the talent wants to go."

Remember when being a Fidelity fund manager was the height of prestige? When young MBAs would do anything to land a job at Goldman Sachs? Those days are over. The dream of Wall Street's brightest lights today--from superstar money managers to freshly minted MBAs--is to start one of the private, non-SEC-regulated investment partnerships known as a hedge fund. No other money management job comes close to inspiring the same awe or glitters with such Hollywood-like glamour. No other career in finance gives you the freedom to be your own boss and invest in anything, anywhere, that gets your juices flowing. (Quips one manager: "I can wager your money on the Knicks game if I want.") And most important: Nowhere else on Wall Street can you get so rich, so fast, so young.

One result is what Ross Perot would undoubtedly describe as a giant sucking sound--that of hedge funds draining top-shelf talent from all over Wall Street. The poster boy of defectors is Jeff Vinik, who traded the world's most famous mutual fund, Magellan, for his own hedge fund in 1996. Lots of others followed. Andrew Fisher, a top fixed-income trader for Salomon, launched a hedge fund this April 1. Cliff Asness, who built Goldman's global arbitrage business (and whose strategy, says one source, contributed $90 million in profits to the firm in 1997), also took off. Jon Jacobson, who managed part of Harvard's endowment for more than seven years, announced in late April that he was leaving. Harvard's response? They're investing $500 million in his hedge fund.

The exodus has Wall Street worried. Ask who is heading to hedge funds, and you will hear "the best and the brightest" so often, you'll wish there were another cliche. How do, say, Putnam and Fidelity feel about it? "They're terrified," says David Barrett, co-head of asset management practice at the recruiter Heidrick & Struggles. "When I speak at mutual fund industry conferences, everyone asks me what they can do to prevent it. I answer not much--they can't compete financially." Even Byron Wien, Morgan Stanley's respected chief investment strategist, is talking about a "brain drain." Says Wien: "This raises the question of who will manage the big money in the future."

To hear the giant sucking sound up close, stop first at 237 Park Avenue in midtown Manhattan, a building some occupants call the Hedge Fund Hotel because it is home to so many funds. There, in a one-room office on the ninth floor, Leonard Panzer, 29, and Matt Rich, 29, sit across from each other monitoring the market and making trades. The team's self-described number cruncher, Phil Anderson, 31, is perched at a desk off to the side. Rich and Panzer used to be brokers; Anderson was a research analyst. Last July the three began talking about starting a hedge fund. By April 1, they had raised $5 million, and Balfour Equity Partners was in business.

With no need for a mutual fund's complex administrative infrastructure, a hedge fund can be surprisingly easy to start. Furman Selz, the brokerage that subleases the space, provides Balfour with everything from offices to Bloomberg terminals and computers--even lunch on Fridays. In return, Balfour clears its trades and does its investment borrowing, or leveraging, through Furman. If a hedge fund manager wanted to focus her brainpower on picking stocks, rather than executing trades, she could even rent a trader from Furman. With that sort of help, all you really need to start up your own hedge fund is $15,000 to $50,000 for legal fees, an accountant, and--oh, yeah--the patronage of a few wealthy investors.

Like most hedge funds, Balfour is organized as a limited partnership, a legal structure that allows it to escape SEC regulation as long as it conforms to certain rules, such as who can invest. (One way to conform is to require individual investors to have a net worth of $1 million.) Rich, Panzer, and Anderson are the general partners, which gives them discretion over the assets contributed by the investors, or limited partners. The typical manager's fee is 1% of assets annually, plus--in the most striking difference from the mutual fund model--20% of profits. Payday comes just once a year, when the performance is tallied up. That means that Balfour's general partners are living on savings until next spring. And should they post negative numbers, they'll have to make their investors whole before they collect a cent.

Balfour's command room at 237 Park is strewn with papers; all three guys are dressed in chinos and shirtsleeves. There's a suit hanging on the back of the door, just in case a visitor needs to be impressed. It's a constant struggle to keep them talking about the hedge fund business--they want to talk about the stocks they're buying. But there's no question they're sold on their jobs. "My hairline has stopped receding because I'm finally having fun," says Rich. To these guys, there are only two reasons to work at a mutual fund: You can't raise money, or you don't have the guts to go out on your own.

And who could argue? If you succeed at all in running a hedge fund these days, you stand to get ridiculously rich. "If I could make the sound of a cash register, I would," says Andrew Guillette, a consultant at Cerulli Associates. Perhaps the most famous hedge fund ca-ching! occurred in 1992, when George Soros became the first person to make $1 billion in a single year, thanks to a shrewd bet against the British pound. While few have done that well, each year about half of the top 20 names on the Financial World list of Wall Street's highest-paid professionals are hedge fund managers. (In 1996 you had to earn $57 million to make the top 20.) It's "the best way for an able money manager to accumulate really serious money quickly," says Wien. "It is better than being a rock star or a professional athlete."

To see how the money adds up, take a look at Jeff Vinik's fund, which returned around 100% in its first year. Vinik is managing around $800 million, so his annual 1% fee would have brought in around $8 million. But the real windfall comes from that 20% incentive fee. On the fund's $800 million in profits, that works out to $160 million, or a total paycheck of $168 million. Even a job at Goldman Sachs can't compete with that. "Unless you're a top-tier investment banker in a hot group, or the world's greatest trader, there's no way you'll make this kind of money," says Robert Schulman, president of investment management firm Tremont Advisors.

By now, though, a skeptical reader may well be asking: Do investors in hedge funds also tend to make out like bandits? Good question. The surprising answer is that while some funds obviously do very, very well, the average hedge fund's return is way less exciting. Consider the performance index compiled by E. Lee Hennessee, who has been tracking hedge funds for over a decade. It has appreciated a relatively restrained 17% annually (net of fees) from 1990 to 1997, slightly shy of the S&P 500's 18%. In other words, the brightest and best-equipped alchemists of finance, whose services have been reserved for only the richest of clients, have offered returns not quite equal to those anyone could have received by buying a simple index mutual fund.

Even more unnerving: It's clear that many of today's hotshot managers have never managed money through anything resembling a challenging environment. According to a database created by Managed Account Reports, fewer than 5% of existing hedge funds were around ten years ago. Are the 95% of fund managers who have never seen a prolonged bear really savvy, or are they bull-market geniuses whose easily won successes haven't prepared them to prosper in an downturn? "It's true that the best minds are drawn to the hedge fund business. But there are not as many great minds out there as there are hedge funds being started," says Antoine Bernheim, who publishes the U.S. Offshore Funds Directory.

Still, as long as the market continues its upward ascent, the majority of investors are unlikely to pay much heed to such flashing yellow lights. And on the supply side of the hedge fund business, the new crop of managers are quick to point to other rewards of the job beyond its often spectacular payouts. Many wax poetic on the pleasures of cutting loose from the constraints of a big organization and of knowing that the credit for success is theirs alone. Andrew Boszhardt, 41, and Anthony Scaramucci, 34, for example, left Goldman about 18 months ago to found Oscar Capital Management, which now runs $700 million, $400 million of which is in their flagship hedge fund. The pair, who idolize Warren Buffett and like to talk about mundane things like return on capital and tax efficiency, beat the market over five years at Goldman. Still, says Scaramucci, "part of our track record at Goldman is Goldman's." Adds Boszhardt: "If you don't break away from your parents, you can never claim 100%."

Hedge fund managers also say they relish the satisfaction of running money without the restrictions of more conventional investment vehicles. The manager of a large-cap equity mutual fund, for example, may be required to mirror the weightings of the S&P 500 in her portfolio. That would mean keeping a certain portion of assets in, say, retail stocks, regardless of your opinion of the sector. That's what hedgies refer to as dead weight. A mutual fund manager also has to contend with daily cash inflows--money that has to be put to work, regardless of whether or not the manager has any good idea about where to put it. (Hedge funds usually take in new money only once a quarter.) "I never want any of my money in my 48th- best pick!" says Anderson.

The beauty of a hedge fund from a manager's point of view is that it puts every financial tool imaginable at your disposal: short selling, margin loans, all sorts of derivatives--everything you need to make money and control your risk in every kind of market. "We have much broader powers to accentuate returns and moderate risk," says Boszhardt. He and Scaramucci, for example, have about 25% of the Oscar fund in American auto stocks, including around 10% in Chrysler alone. Such a large stake would be prohibited at many mutual funds, but Oscar has held that position since the fund's inception. When the pair find a stock they view as particularly undervalued (like Chrysler), they will use leverage to increase the position and magnify gains; they will also sell short to defend against a market decline. It works: The fund was up 80.9% last year and 25% so far this year.

The ability to use a broad selection of financial tools was one of several reasons Carole Berger, 49, a top financial services analyst for 23 years, left Salomon after the Smith Barney merger to open a hedge fund. "I thought about starting a mutual fund," she says, "but you don't have all the arrows in your quiver." Berger also points to changes on Wall Street that left her less enthusiastic with her job. "Twenty years ago it was more academic; today it's driven more by marketing and investment banking." That's a common complaint among hedgies who fled analysts' jobs. "I'd find these terrific little stocks that I knew would make my clients money," says Balfour's Anderson, "but I couldn't cover them because it wouldn't bring the firm any investment banking work."

Freed from the divided loyalties of their former Wall Street jobs, hedge fund managers feel their interests and those of their clients are well aligned. Most have a substantial portion of their net worth in their funds, and many have the money of their nearest and dearest as well. "If this doesn't work," says Berger, "not only do I have no job and no savings, but I can't go home to my mother because I have her money too."

Since hedge funds are not allowed to advertise, the crucial job of gathering assets tends to be a clubby, word-of-mouth endeavor, heavy on personal contacts. Young hedge fund managers often collect their seed capital from friends and family, while more established managers tend to bring it with them from their previous job. Boszhardt and Scaramucci, for example, founded Oscar with $150 million, most of which walked out of Goldman with them. It also helps to know your audience. Larry Bowman, who departed Fidelity 4 1/2 years ago, launched the Founders Fund last July. It's open only to entrepreneurs who've founded a company, and to keep the fund from becoming unmanageably large, it takes no investment greater than $500,000. Says one source: "People are beating down the door to get in." Bowman laughs: "I've discovered that the best way to market to billionaires is to tell them no."

Once a fund posts some solid returns--not a difficult trick in the current market--attracting assets ceases to be a problem. Says one industry source about the stampede to give assets to the next hot young hedge manager: "You start with a Rolodex and a few people who have the warm fuzzies for you. Then you put up a year of good performance, and money floods in."

In a way, the demand for hedge funds is surprising. Millionaires, after all, would seem to be a fairly finite, well-chewed-over market. However, 16 years of bull market and economic expansion has left the pool of potential hedge fund buyers larger than ever. According to investment management consultant Cerulli Associates, there are now about six million millionaires in the world, with some $17 trillion in total assets. And while wealthy individuals still account for 80% of hedge fund assets, institutions are also starting to buy. Harvard, Yale, Stanford, and Duke have all dedicated a percentage of their endowment assets to hedge funds. The Virginia State Retirement system has $1.8 billion in domestic equity hedge funds.

Some of that money is pursuing the aura of exclusivity and glamour that hedge funds confer. Owning a hedge fund signals that you're wealthy, sophisticated about money, and in the know. It's no longer hip to blab on about your Putnam big-cap U.S. value fund (how retail). But the Firebird Fund, a hedge fund that invests in Russian equities and has returned 636% since its inception in May 1994--now, that has cachet.

But fundamentally, hedge fund mania is all about two familiar emotions on Wall Street: greed and fear. Many investors come to hedge funds looking for mind-blowing performance numbers like Soros' Quantum Fund's 32.6% average net annual returns since 1969. (That means $1,000 invested then would be worth $3.52 million today.) Or the 60% average annual gains, net of fees, earned by Larry Bowman's Spinnaker Technology fund over the past three years. Says William O'Connor, a portfolio manager at the Marshall Funds in Milwaukee: "People are bored with the returns of the stock market. They want to push the envelope."

Occasionally, though, the envelope pushes back. The heavily leveraged investing that magnifies a manager's smart moves has an equal and opposite effect on his less successful bets. Last fall, for example, Victor Niederhoffer's fund lost all its investors' money in wrong-way bets on the Thai baht and S&P futures; last winter Barbara Doran shut down her fund after making big, leveraged bets on tiny stocks that went down instead of up.

In general, though, such spectacular failures have been rare. In part that's because, for all the tactical leeway they enjoy and all the exotic instruments they can deploy, hedge fund managers in general try to control risk rather than simply maximize returns. Most tend to stick to a tightly focused investing strategy, such as short selling, risk arbitrage, or playing equities with both long and short positions. And the overarching goal for all hedge funds is to make money whether the market goes up or down.

Currently, any reasonable investor has to be aware that the days of 30% annual gains on the S&P 500 are numbered and that the market is bound to revert painfully to its long-term average return of 10%. That fear also helps to explain the stampede into hedge funds. Investments that at least claim the flexibility to prosper in both rising and falling markets have a lot of appeal these days, even if most fail to match the market's current breakneck pace. (It also doesn't hurt that investors appear unaware that most of the average hedge fund's shortfall vs. the indexes came in recent years, when a hedge fund manager's vaunted ability to sell short and take other defensive measures actually proved more an impediment than a boon.)

In the meantime, there is certainly no sign that the cash flow into hedge funds is about to let up. "I think we're in the second inning of a nine-inning game," says Joe Malvasio at Furman Selz. According to a new report by KPMG and RR Capital Management, institutions still allocate less than 1% of their $11 trillion in investable assets to hedge funds. Even wealthy in-

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[dividuals have less than 2% of assets in hedge funds. Imagine what an impact just a slight shift in those dollars would have.

And as long as the money keeps flowing into hedge funds, talented people will continue to pour out of mutual funds, trading desks, investment banks, and Wall Street research departments. Wall Street, if not yet resigned to its inability to stanch the flow, seems to have decided that if hedge funds can't be beat they can at least be co-opted. Money management firms, investment banks, and even stodgy old banks are putting their clients' money into hedge funds. The biggest co-opter, Alliance Capital, has a $2 billion hedge fund business that's being fattened by $100 million a month in fresh capital. Insurance company AIG has a hedge fund too, and Chase Manhattan oversees around $700 million in hedge fund assets.

That can raise a whole host of interesting issues, compensation being one of the more obvious ones. (Imagine Mr. Mutual Fund and Ms. Hedge Fund in neighboring offices. He collects salary; she gets 20% of profits. Hmm.) Still, some say that Wall Street will reclaim its own and the independent, freewheeling hedge fund industry will consolidate into lumbering mutual fund-like complexes. The RR Capital/KPMG report on hedge funds asks: "Who will be the Fidelity of hedge funds?" It's enough to make any self-respecting hedgie shudder.

They may yet be spared such indignity. There have been other times--like the 1960s--when hedge funds were sprouting like weeds. Each time, a sour stock market spoiled it.

Indeed, anecdotal signs of excess are surfacing this time round as well, the sorts of things that in retrospect tend to be seen as a clear sign that a boom is nearing its end. "I've had people who inherit $5 million, can balance their checkbooks, and have a Schwab One account call me up saying they want to start a hedge fund," says one source. It's tempting to laugh, but then again, who wouldn't want to start a hedge fund?]