The prospect of higher investment returns is a tempting one - but look before you leap. By Rachel Fixsen
You may have grasped the idea of unit and investment trusts, but hedge funds remain a mystery for most investors. Last year's high- profile crash of a star hedge fund, Long-Term Capital Management, has given hedge funds a bad name. LCTM had to be bailed out to the tune of $3.6bn.

But hedge funds aren't necessarily villains, and surely they can also offer the chance of high returns? After all, these investment vehicles have feathered the nests of some of the world's richest people. Billionaire financier George Soros' Quantum Fund is a global hedge fund now worth pounds 4bn plus.

Hedge funds are very specialised investments, and do not operate on the same principles as standard market funds. Instead of broadly mirroring the movement in the market as a whole, many aim to achieve an good return whatever the stock market does - taking a "market-neutral" approach.

Typically, the manager takes advantage of potential growth in certain sectors and avoids likely weakness in others. As a simple example, if banks appear likely to report better-than-expected profits while higher interest rates are hitting property shares, the fund might buy banks and sell or "short" property shares for a quick gain. Some funds may use arbitrage, exploiting, usually tiny differences in market prices between one financial centre and another. Others may buy "distressed" asset-backed debt, paying less than the asset value the loans are secured on. Global macro-economic hedge funds, such as Quantum, may use any or all these strategies, depending on the situation.

Just how risky are hedge funds? Independent financial advisers tend to avoid them, partly as their complexity means clients may not fully understand the risks, leaving IFAs open to compensation claims should the investment dive. But Michael Goldman, MD of Momentum Asset Management says public perception of hedge funds as high-risk is wrong: "They are unbelievably diverse... and more than half are extremely conservative."

One thing they have in common is their ability to go "short" - sell an asset they do not own to make money if the price falls. While many follow a market-neutral strategy, not all do. "A fund is often only a hedge fund because it invests in something that's forbidden for unit trusts," says Mr Goldman. They often make heavy use of derivatives such as futures and options, and become highly geared - magnifying potential gains but leaving them vulnerable to indigestible losses. Hedge funds adopting a market-neutral strategy can be used as a counterweight in an overall portfolio exposed to the bond and stock markets.

Global Asset Management, for example, runs an offshore hedge fund, GAM Arbitrage that "is not going to shoot the lights out in bull markets but can maintain consistent long-term performance", says Dana Moore, of the Bermuda-based firm. And Momentum's Allweather hedge fund has kept annual returns at between 10 and 15 per cent for the last four years.

Mike Newman of Best Investment says the only type of hedge fund he would recommend is one with a market-neutral approach. "One that will show consistent returns," he says - a far cry from hedge funds' popular image. So if hedge funds strive to be so tame, why should smaller investors steer clear? For a start, their highly geared positions mean they can be very exposed. Any fund manager can make a mistake, but gearing (borrowing to invest) can translate that error into crippling, rather than manageable losses. Also, as offshore funds they are not required to have the supervision of trustees or a board of directors as do UK-incorporated investment or unit trusts.

A market-neutral approach should shield a fund from the lows of equity markets, but it may still be exposed to other risks. For example, LTCM's performance may have been independent of the stock market, but the fund was vulnerable to the credit risk of junk bonds. The tax treatment of gains from most hedge funds make them difficult to justify for most UK investors, says Mr Newman. Most are offshore investments, and lack distributor status, so gains are subject to income, not capital gains, tax and higher-rate tax paying investors can't use their capital gains tax allowance "so you're 40 per cent down at the start".

At least one hedge fund has tried to attract UK investors. Finsbury International Hedge Investment Company invests in a range of hedge funds worldwide. It is managed in Guernsey, but has a full London Stock Exchange listing, so solving tax problems. But the bid-offer spread is very wide, at about 10 per cent, and the shares are not very liquid, says Mr Newman. Tim Cockerill, of independent advisers Whitechurch Securities, says hedge funds are only suitable for the professional investor - "because the risk is high, and you've got to take an active interest: you can't tuck it away and wait for a nice return," he says. Many hedge funds have high minimum investments and require you to lock the money away for some time.

Charles Levett-Scrivener of Towry Law, another independent adviser, agrees, saying their complexity alone is reason to steer clear. "If you don't understand it, don't buy it," he warns.

`The Independent' has a free `Guide to High Risk/High Reward Investment', outlining ways to get higher returns using an aggressive approach. Sponsored by Whitechurch Securities, it's available by calling 0845 2711003. Towry Law: 01753 554400; Whitechurch Securities: 0117-9442266; Best Investment: 0171-321 0100