Yet despite the fact that, world-wide, the industry is worth $80bn and that, according to Fortune magazine, six of America's 10 richest men are hedge fund managers, many UK investors remain suspicious. In the US such managers are viewed as respected members of the investment community, but in the UK an image persists of shady, derivative-trading cowboys operating outside the system. The truth, in fact, could not be more different.
Much of the mystery surrounding hedge funds is down to the fact that, by law, they are not permitted to advertise. Unlike most unit or investment trusts which are classified as collective investment schemes under the Financial Services Act, hedge funds are not regulated. As a result, investors enjoy much less protection.
While regulated funds have very strict rules imposed on them (in, for example, the amount of derivatives they can use), hedge fund managers can make up their own rules. And the fact that their hands are not tied gives rise to the single biggest difference between hedge funds and other pooled investment vehicles: hedge funds can, in the parlance, sell "short". In simple terms, managers can sell shares which the fund does not own.
A large and sophisticated securities lending industry exists for managers who wish to sell short, providing a marketplace in which they can borrow shares in bulk which they believe are going to perform badly. They then sell these shares on at the market price - a price which they believe is overvalued - and buy them back once their price has dropped. If the strategy works, they will have sold them for rather more than they end up buying them back at. It can be a difficult concept to grasp, but is simply the reverse of the old stock market adage, "Buy cheap, sell dear". Either way, the result is the same: a net gain.
The main advantage of being able to sell short is that it allows funds to make money in a falling market. In addition, if the manager can buy (or go "long") stocks which do well while simultaneously shorting stocks which perform badly, the returns can be astronomic. In good years some hedge funds have returned more 100 per cent, and many funds in the US returned 70 per cent last year - massively outperforming the US equities market as a whole.
Of course nothing in life is that easy and selling short is not an automatic route to riches. In a sustained bull market, for example, where all share prices are rising, short sellers can get their fingers badly burnt. However, managed sensibly, the portfolio should, in theory, be able to control risk more efficiently than a fund in which shorting is not permitted.
Giuseppe Ciardi, fund manager at the London-based Park Place Capital, which runs two offshore funds, explained the appeal: "It is the flexibility of hedge funds which makes them so attractive to investors." he said.
"Because of the ability to sell short volatility can be kept relatively low and, managed responsibly, hedge funds can be less risky than just buying an index like the FT-SE, which can suffer quite violent turns of fortune."
He went on to say that the traditionally risk-averse US pensions industry is beginning to farm out money to hedge fund managers in an attempt to outperform their benchmarks.
Crispin Odey is founder of Odey Asset Management and one of the rising stars of the UK hedge fund community. He puts his company's success down to the fact that most hedge fund managers are highly qualified market players. "Entering the equity market is like going into a casino," he explained. "Would you advise an inexperienced punter to go into a casino? The answer is no - unless, of course, you know the system. What we have done is worked out ways of beating the system".
Different hedge funds exist to attract investors with differing attitudes to risk. Although most invest in equities, some funds play the currency or bond markets while others dabble in commodities. Some will make heavy use of derivatives while others will be highly geared (in effect, they borrow money which allows them to run up much larger positions than the fund actually owns). There are also funds of funds which invest in a broad range of hedge funds in an attempt to diversify away the risk.
In the US, directories are published which list all the available funds (there are about 1,200 world-wide). For UK investors, however, determining which funds exist and who runs them can be a time-consuming business. Their prices are listed in the "Other Offshore Funds" section of the Financial Times but no telephone numbers or addresses are given and this is quite deliberate. Not only are hedge funds not permitted to advertise in the UK, but members of the public are forbidden from approaching them directly and must go through a broker. As a result, most investors tend to be seasoned market professionals.
In the UK you will still be asked to put up a minimum stake of around pounds 100,000.Reuse content