How to get your own piece of the hedge fund action

Iain Morse explains the ways private investors can enter an enticing arena

George Soros eat your heart out. The man who made billions from hedge funds now spends his time making charitable donations. Now it is the turn of individual savings account (ISA) investors. Under new tax rules they will soon be able to invest in a much wider range of assets, including hedge funds. The change in the ISA rules could finally turn the sector into a mainstream investment.

Not a moment too soon, say fans of the sector. Until last year, hedge funds were the stars of the investment universe, repeatedly rewarding investors with double-digit returns and portfolio diversification.

The largest funds have performed so well that they have become hugely powerful. Last month, shares in easyJet fell on five consecutive days - knocking 10 per cent off the value of the company - because hedge funds were selling the stock short. The funds are so huge that the fact they were betting on shares in easyJet falling - short selling in the jargon - was enough in itself to bring down the price

As with other assets, however, success is not guaranteed. Last year, hedge fund managers enjoyed spectacular growth in funds under management, but often failed to beat the returns achieved by major bond and stock markets.

Fund managers in the sector concentrate on absolute returns - what their funds achieve, rather than how they compare with rival investment classes. But here, too, returns fell last year - the broad InvestHedge Composite Index, compiled by Hedge Fund Intelligence, was up only 6.4 per cent during 2004. Most other composite indices told the same story.

Critics of the sector say that while hedge funds' ability to raise massive sums has in the past enabled them to exploit market inefficiencies, the sector is now so big it has eradicated these inefficiencies.

Risk is an important consideration. Depending on a fund's style, it may have little or no correlation to asset classes such as equities or bonds. That can make the right funds a useful way to diversify a portfolio.

So how do private investors get exposure to hedge funds? It can be difficult. Funds are often organised through private partnerships run in offshore financial centres with little or no regulation. Managers will have their own money in the fund, while third-party direct investors join as limited partners, taking an agreed profit share. Needless to say, you need a lot of money as a limited partner - in some cases, at least £1m to £10m.

The good news is a growing number of reputable providers, including MAN Group, HSBC and Martin Currie, offer access to better regulated, open-ended funds. Martin Currie, for example, accepts minimum premiums of $100,000 (about £55,000) into its hedge funds, which are run from Edinburgh.

The same applies to Man Group, which distributes own-brand funds such as Diversity, and manages funds for distributors such as Close Brothers.

"The range is wide," says Anthony Yagdaroff, managing director of investment adviser Allenbridge, which specialises in hedge fund research. But he warns: "Many are US dollar denominated, exposing UK investors to currency risk, and typically requiring a minimum premium of $25,000."

Another problem is that while these products are freely sold in the US and most of Europe, few are regulated by the Financial Services Authority (FSA), the chief City regulator.

Alternatively, new products are hitting the market. Pinder Fry & Benjamin's Guaranteed Hedge Index Fund offers to replicate the return of the FTSE Hedge Index, which has averaged 14 per cent a year in the past five years. It has a minimum investment of £10,000 and will run over the next five years.

But the easiest way to get exposure to the sector is through one of a growing number of investment trusts that buy into hedge funds. These funds of funds can be bought and sold like any share, which means that investors are not locked in. These are funds ISA investors could soon be able to buy.

Currently, there are 10 trusts available, all offering a blend of styles and managers in risk-adjusted and actively managed portfolios. The only downside is that performance has been patchy. Alternative Investment Strategies, launched in December 1996, has so far returned 175 per cent of capital invested against 152 per cent for the FTSE All Share index. The trust's dollar-denominated performance has varied from 38.89 per cent in 1999, through 0.78 per cent in 2000, to 10.39 per cent last year, though in no year has it lost money.

The fund, originally marketed by Close Brothers, has 58 per cent of its portfolio in equity long-short hedge funds.

Less excitingly, Thames River Hedge + returned 7 per cent from launch in January 2004 to the end of January 2005. "Last year was a very difficult year for hedge funds," explains manager Ken Kinsey-Quick. "It was an inflection point between long-term interest rates falling and rising that dampened volatility and returns."

Then there is the Dexion Absolute Return fund, launched in January 2003, which has done reasonably well, with a 21 per cent gain since launch. In 2003, the fund rose 12.59 per cent; in 2004, it returned 8.13 per cent and this January added another 0.29 per cent.

Other fund managers active in the sector include Close, DWS, HSBC, Man Fund Management and Progressive.

Finally, there is one other way to get exposure to the success of hedge funds. Provider MAN Group is listed on the London Stock Exchange. Now valued at £4.3bn, large enough to be included in the FTSE 100 Index, its share price currently stands at 1396p.

HOW HEDGE FUNDS WORK

Hedge funds are different to traditional forms of investing. Above all, they can take "long" and "short" positions. The former is what traditional investment is all about, a bet that the value of the asset you buy will rise. The latter, however, is a bet that an asset's price will fall. Using both techniques, hedge fund managers should be able to make money, whatever the market conditions.

Hedge fund managers also hold a much wider range of assets. They invest on the derivatives markets, as well as buying shares, bonds, currencies and commodities. Some invest in private equity, while others hold property.

In fact, the hedge fund universe is very broad. Investors buying into a particular fund are taking a gamble on a particular investment style and the talent of one or more managers to meet their return targets.

Comparing hedge funds is of little real use: there are at least 40 separate styles, ranging from global macro to convertible arbitrage, from equity long-short to distressed debt arbitrage.

Not all funds are aggressive - some simply seek to produce slightly better returns than cash, with very limited risk.

Some funds are single strategy while other pursue several ideas at the same time. Others are run on the judgement of a single manager, and some use computer-driven programmed trades that, once set up, work without human intervention.