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; request a free guide on NISAs from Hargreaves Lansdown

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