Investors walk on the wild side with hedge funds

These complex instruments are coming to the man on the street... Will who dares win?

The idea of planting a hedge fund in an individual savings account might fill some investors with horror.

Unregulated and based offshore, the reputation of these funds as financial monsters, capable of wreaking awesome destruction, goes before them.

The funds deploy an array of sophisticated financial tools such as derivatives and options to "hedge" their bets and try to make money, or "absolute returns", for investors - regardless of whether stock markets go up or down.

Usually the preserve of the wealthy, requiring £50,000 to buy a piece of the action, they can borrow money to "gear up" and take eye-watering financial bets on commercial and geopolitical events.

While they try to make money, things can go badly wrong when they don't.

Some may recall the collapse of the Long Term Capital Management (LTCM) hedge fund in 1998, when its currency bets unravelled in the wake of the crisis in Russia's financial system. In just a month, it lost billions of dollars.

Even when they're successful, they can cause huge fallout. That was the case in 1992 when currency speculator George Soros and his Quantum hedge fund bet that the weak pound would fall out of the European exchange rate mechanism. It did and he made £1bn in the process of ravaging sterling and playing havoc with British interest rates.

Most recently, hedge funds emerged as temporary homes for the money in the tangled business affairs of David Mills, the husband of Tessa Jowell, the Secretary of State for Culture, Media and Sport.

While the links between these secretive, mammoth funds and the individual investor might seem remote, they may be about to move closer.

In the next two weeks, the Financial Services Authority (FSA), the City regulator, will publish its view of the current ban on the marketing of hedge funds to ordinary investors.

For eight months, it has mulled over the risks of the funds and their availability to consumers, as well as the wider financial markets.

The FSA stressed last summer that both consumers and companies might not fully understand these products and be confused by the different types of fund, exposing them to the risk of mis-selling.

But it also expressed concern that "consumers may be missing out on investment opportunities because of the current restrictions on the marketing of unregulated products".

Although it is unlikely the FSA will now lift the marketing ban, it is anticipated there will be some acknowledgement that more could be done to introduce hedge funds carefully to the wider public.

"There's expectation that the regulator ... could be more in favour than it has been so far," says Tim Cockerill of independent financial adviser (IFA) Rowan.

"This is because the hedge fund sector has developed and there are a lot more [related] products open to [individual] investors that are bridging the gap."

These bridge-builders are the more easily accessible "quasi-hedge fund" products, says Justin Modray of IFA Bestinvest.

They include a batch of new, comparatively conventional investment initiatives such as the UK Absolute Alpha unit trust fund run by fund manager Merrill Lynch; the Prosper 80 "structured product" from Old Mutual; and Alternative Investment Securities (AIS), a listed firm that acts as a "fund of hedge funds".

These simpler products have special dispensation to attempt to replicate hedge fund practices, or to make money by spreading your cash across a large number of hedge funds.

To get a flavour of how they work, it's worth looking first at how hedge funds themselves use elaborate strategies to make money.

Among these are "going short" - another name for selling shares in the hope of buying them back later at a lower price. Imagine a company's share price stands at £1 and a hedge fund manager thinks they'll fall to 50p over the next month. For a small fee, he or she '"borrows" 10,000 shares from somebody who already owns the stock, and then sells them for £10,000.

Four weeks later, if everything has worked out perfectly, the shares are worth 50p. The manager buys them back at a cost of £500 and - minus the borrowing fee - has made a neat profit.

Of course, the same shares could have risen in value and made the manager - and your cash - a loss.

Other financial levers used by hedge funds include buying stock in two market rivals - J Sainsbury and Tesco, for example - to take advantage of any industry boost and also cover themselves against a poor individual company performance.

Also popular is "arbitrage", where managers pounce on price movements in commodities such as sugar or coffee.

Although hedge funds have a reputation for being high-risk, their job is actually just what it says on the tin: to hedge against risk.

"The concept of hedge funds makes a lot of sense. Extended logically, everybody could have exposure to one," says Mr Modray.

"In practice, of course, it's another story."

As well as the high fees for buying in - $100,000 (around £60,000) for any hedge fund listed in Dublin - many funds are now closed to new money and there's no guarantee of decent performance.

Not all hedge funds disclose full information, warns Mr Modray, and that undermines the accuracy of the global CSFB/ Tremont index, which tracks the performance of the funds. In the three years to 28 February, a period of rising stock markets, this index grew by 37.9 per cent, compared to an 85.6 per cent rise in the FTSE All-Share index of companies.

But for individual investors, the choice is best limited to the funds of hedge funds and "absolute return" vehicles - and these should make up no more than 5 per cent of your overall portfolio.

The Merrill Lynch fund can sell shares short and use derivatives. Its top three holdings at the end of January were Tesco, property company Hammerson and the HBOS banking group.

It grew by 3.3 per cent in the six months to 31 January but has a higher annual management charge (AMC), 1.75 per cent, than a mainstream unit trust and is set to introduce the option of a 25 per cent "performance" fee on gains above a set amount. The minimum investment is either a £10,000 lump sum or £250 a month.

Alternatively, the Old Mutual Prosper 80 is actually a structured product regulated by the FSA. Its managers, however, use hedge fund activities to generate cash. The minimum investment is £5,000 and the AMC is 1.9 per cent.

Separately, you can buy shares in AIS, though you will have to pay dealing costs and find a willing seller.

Before any investment in these products, visit an IFA to ensure you appreciate all the risks involved.

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at

Finacial products from our partners
Property search
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    SThree: Graduate Recruitment Resourcer

    £20000 - £22500 per annum + OTE £30K: SThree: SThree Group have been well esta...

    Guru Careers: .NET Developer / Web Developer

    £45K - £55K (DOE) + Benefits: Guru Careers: We are seeking a full stack .NET D...

    Ashdown Group: Treasury Assistant - Accounts Assistant - London, Old Street

    £24000 - £26000 per annum + benefits : Ashdown Group: A highly successful, glo...

    Ashdown Group: Business Analyst - Financial Services - City, London

    £50000 - £55000 per annum: Ashdown Group: Business Analyst - Financial Service...

    Day In a Page

    Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

    Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

    How a costume drama became a Sunday night staple
    Miliband promises no stamp duty for first-time buyers as he pushes Tories on housing

    Miliband promises no stamp duty for first-time buyers

    Labour leader pushes Tories on housing
    Aviation history is littered with grand failures - from the the Bristol Brabazon to Concorde - but what went wrong with the SuperJumbo?

    Aviation history is littered with grand failures

    But what went wrong with the SuperJumbo?
    Fear of Putin, Islamists and immigration is giving rise to a new generation of Soviet-style 'iron curtains' right across Europe

    Fortress Europe?

    Fear of Putin, Islamists and immigration is giving rise to a new generation of 'iron curtains'
    Never mind what you're wearing, it's what you're reclining on

    Never mind what you're wearing

    It's what you're reclining on that matters
    General Election 2015: Chuka Umunna on the benefits of immigration, humility – and his leader Ed Miliband

    Chuka Umunna: A virus of racism runs through Ukip

    The shadow business secretary on the benefits of immigration, humility – and his leader Ed Miliband
    Yemen crisis: This exotic war will soon become Europe's problem

    Yemen's exotic war will soon affect Europe

    Terrorism and boatloads of desperate migrants will be the outcome of the Saudi air campaign, says Patrick Cockburn
    Marginal Streets project aims to document voters in the run-up to the General Election

    Marginal Streets project documents voters

    Independent photographers Joseph Fox and Orlando Gili are uploading two portraits of constituents to their website for each day of the campaign
    Game of Thrones: Visit the real-life kingdom of Westeros to see where violent history ends and telly tourism begins

    The real-life kingdom of Westeros

    Is there something a little uncomfortable about Game of Thrones shooting in Northern Ireland?
    How to survive a social-media mauling, by the tough women of Twitter

    How to survive a Twitter mauling

    Mary Beard, Caroline Criado-Perez, Louise Mensch, Bunny La Roche and Courtney Barrasford reveal how to trounce the trolls
    Gallipoli centenary: At dawn, the young remember the young who perished in one of the First World War's bloodiest battles

    At dawn, the young remember the young

    A century ago, soldiers of the Empire – many no more than boys – spilt on to Gallipoli’s beaches. On this 100th Anzac Day, there are personal, poetic tributes to their sacrifice
    Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves

    Follow the money as never before

    Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves, reports Rupert Cornwell
    Samuel West interview: The actor and director on austerity, unionisation, and not mentioning his famous parents

    Samuel West interview

    The actor and director on austerity, unionisation, and not mentioning his famous parents
    General Election 2015: Imagine if the leading political parties were fashion labels

    Imagine if the leading political parties were fashion labels

    Fashion editor, Alexander Fury, on what the leaders' appearances tell us about them
    Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

    Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

    The architect of the HeForShe movement and head of UN Women on the world's failure to combat domestic violence