Hedge funds on the way but are they right for you?

New regulation will finally give investors access to hedge funds, says James Daley

Ever since George Soros's Quantum fund "broke the Bank of England" on Black Wednesday in 1992, hedge funds have suffered from an image problem. Many investors see the funds as high risk, and regulators have been ultra-wary about the risk profile of the sector.

As a result, until now, all but the richest investors have effectively been barred from hedge funds. Not only do most funds require minimum investments of more than £100,000, but the sector is not regulated by the Financial Services Authority (FSA), Britain's chief City watchdog. Accordingly, hedge fund managers are not allowed to promote their products directly to individual investors. However, the FSA announced a modest change of heart this week. The regulator is now considering bringing funds of hedge funds into the fold of products it regulates. That would make the sector much more accessible, with professional managers offering investors exposure to a range of different hedge funds within one vehicle.

Among investment advisers, there is growing recognition that hedge funds could offer even modest savers something new. While it is true that some funds are very aggressive - with volatile returns to match - others are much less so. In some cases, hedge funds offer investors stock-market exposure with much lower levels of volatility and more predictable returns.

"Many advisers add funds of hedge funds to the portfolios of clients who are risk-averse," says Bridget Guerin, a director of investment house Matrix, which offers a range of hedge funds. "They provide a good way of adding some diversity to a portfolio that is mainly invested in fixed interest and equities. If you add one of our fund of hedge funds to a portfolio, you tend to find that you increase the return while reducing risk."

However, Mark Dampier, the head of research at Hargreaves Lansdown, the independent financial adviser, believes that the sector will need to clean up its act before it is widely accepted. He claims that too many funds are expensive, and that it is often unclear exactly what the price of investment actually is.

"The charges are horrendous," Dampier says. "Unlike some people, I really don't like performance-related fees - which most funds of hedge funds charge. You pay more for what you could have got for less."

Nor is Dampier impressed with the argument that paying fund managers extra for outperforming encourages them to do better. "Contrary to what most people believe, such charges often don't align the interests of the investor and the fund manager," he argues. "The funds are usually set against some unchallenging benchmark, beyond which the managers pay themselves 20 per cent. And even if they don't hit that, there's still usually a hefty fee to pay."

François Barthelemy, who is a fund of hedge funds manager at F&C Investments, agrees that hedge funds are complex, but says that this should not be a barrier to the retail investor getting involved.

"While complexity doesn't mean higher investment risk, it does mean that the product needs to be put together in a very professional manner, by those with the right expertise," he says. "That is why I think that funds of hedge funds are the right way for retail investors to get exposure to the asset class."

Barthelemy says he invests all his savings in funds of hedge funds, but he suggests that a typical retail investor should commit no more than 10 per cent of his portfolio to the asset class.

One option already open to smaller investors looking for hedge-fund exposure is to buy shares in an investment trust that has holdings in the sector - a small number of such trusts have been launched in the past five years.

However, Barthelemy warns investors to look at whether shares in such trusts are trading at a discount or at a premium to the value of the underlying assets. Most investment trusts trade at discounts, but in the small hedge fund sector, premiums are more common.

Barthelemy thinks this is unlikely to be sustainable, and may cost investors a few percentage points of valuable returns as these premiums unwind over the coming months.

Performance has also been patchy. Only two trusts have a five-year performance track-record. And, while Close Alternative Investment Strategies is up 52.5 per cent over that period, Xavex Hedgefirst is down 7.5 per cent.

Certainly, investors need professional advice before committing money to hedge funds. If you want to find a specialist independent financial adviser near you, who can advise on the hedge fund sector, visit the website ww.unbiased.co.uk and use its search facility to find an adviser who has higher investment qualifications.

How hedge funds work

The main difference between a hedge fund and a conventional investment fund such as a unit trust is that hedge-fund managers take "short" positions in the stock market. They borrow shares in a company from a third party and immediately sell them, in the hope of buying them back at a cheaper price before repaying the loan.

The idea is to make money even when share prices are falling, so that hedge funds can perform even in a bear market. However, different hedge funds take very different approaches. The most simple are long/short funds - they simply buy stocks they think will rise, and short those they think will fall.

Funds such as George Soros's Quantum, which take very large positions on the back of economic changes around the world, are called Global Macro funds. These are much higher risk, but are well beyond the reach of the majority of investors.

Although there are more than half a dozen hedge-fund strategies, which vary in terms of risk, the majority of funds of funds that are available to private investors are balanced, and invest across a range of different strategies.

Matrix argues that its funds have produced returns of around 8 per cent a year after charges recently, and with much lower volatility than many regular equity funds.