Personal Finance: The place for adventure capital

Hedge funds are high risk but can offer gains in markets that are falling as well as rising

WILL HEDGE funds be the next big thing in retail investment? Seen as high-risk, they offer the prospect of gains in markets which are rising, going sideways, or falling.

Investing in a hedge fund is not for the unwary. Alan Pace, director of international prime brokerage at Lehman Bros, the US investment bank, warns: "There is no exact definition of what counts as a hedge fund and investors should do careful research or take qualified advice before investing. Hedge fund managers can embrace different investment strategies. Also, some have been around for years, others have short track records."

This diversity can partly be explained by the way hedge funds first developed. They were based in offshore tax havens, usually constituted as private investment partnerships, in which managers had a lot of their own money.

Today, there is an estimated 3,500 hedge funds around the world, controlling up to pounds 245bn in assets, with most of this coming from the rich. But providers like Global Asset Management and Fraternity Fund Management have made hedge investments affordable by setting minimum investment levels of between pounds 10,000 and pounds 15,000.

A distinction between hedge funds and most equity investment is the basis on which they calculate returns. Most pooled equity funds are like unit trusts that measure performance relative to a bench mark like the FTSE All Share Index. By contrast, hedge fund managers look for an absolute return. As hedge funds are unregulated they can hold any assets the manager wants to buy, and can "sell short" as well as "buy long".

Nicola Meaden, of Tass, a City firm which researches hedge funds says: "A conventional equity unit trust will 'buy long', buying shares in the hope that they will go up in value. But they are not allowed to 'sell short', against a fall in value."

Selling short depends on a fund manager being able to "borrow" shares for a fee then re-selling them to a third party. Once the share price falls, the manager buys the shares back and returns them to the original lender.

This can be high risk, hence the reason why regulated fund managers are not allowed to do it. But it means that hedge funds can make money while a market is falling and rising.

There is no limit hedge funds can borrow against the assets they own. This explains why some of them have failed badly by managing to lose all of their investor's money.

The dominant styles of hedge fund management are event-driven, global macro, equity hedge and market-neutral. Event-driven funds are common in the US and are now being exported to Europe. They look for profit in so-called "merger arbitrage" and when a firm tries to takeover another they go short on the creditor's shares, while buying up their victim's. Takeovers cost money, but suggest that the victim's shares are undervalued.

They also may buy "distressed stock" - shares in bankrupt firms that still trade in the hope of making a recovery.

Global macro funds may be active in any asset class, Meaden says: "The Soros funds fall into this category, and typically funds like this will do a lot of research on their chosen asset class. Bets on interest rates and currency values are common."

Equity hedge funds are run by stock pickers - managers who research particular shares or sectors thinking they can beat the market.

Market-neutral funds hold two or more assets whose risk and return values offset each other. "These tend to be quantitative and often make money from identifying price anomalies or inefficiencies in a market," Meaden says.

Managers may try to "equalise" the risk of a market falling or rising, by selling short and buying long. Another small category is "short sellers" which carry portfolios heavily weighted to going short, or selling against an expected decline in the value of a share category or an index like the FTSE All Share.

Hedge funds are not presently authorised in the UK by the Financial Services Authority, the City's top regulator. They are not permitted to advertise or sell direct to the public. Buyers must find a stockbroker or independent financial adviser who will deal in them, but not all of them do.

Christopher Cottrell, Managing Director of mutual funds at GAM, says this is a pity as "we take the view hedging is about reducing not amplifying risk. We run developed hedge funds as part of a portfolio management service for private clients. if these funds were properly regulated it would help to get rid of cowboys."

The most accessible hedge funds for those with limited means are "fund of funds", like GAM's Diversity Fund. Started in 1989, it controls assets of more than $1.1bn and has grown by 14.95 per cent per year compound since its launch.