Fiendishly complex, frighteningly expensive and hidden offshore away from the City regulator's prying eyes, hedge funds have been the sort of financial products that keep investors awake at night. Get them right, however, and they can be the stuff of dreams: some investors have doubled their money in a year.
Financial advisers have recently reported a surge in interest in a financial instrument that was once the preserve of the fabulously wealthy. After years of unreliable stock market returns for more orthodox products, hedge funds have crept on to mainstream investment radars. "Their popularity stems from the bear market," says John Turton, director of life and pensions at independent financial adviser (IFA) Bestinvest. "Investors are asking how they can avoid losing money again."
They may be growing in popularity but ask someone in the street what a hedge fund is and you are likely to get a blank look. This isn't surprising, as hedge funds can't be marketed to the average investor because the Financial Services Authority (FSA), the City regulator, deems them too risky. The usual way to buy them is through a specialist broker or adviser.
Those who have heard of the funds usually connect them with George Soros, the billionaire financier who forced the UK out of the European Exchange Rate Mechanism in 1992 by betting on the falling pound. But today's hedge funds tend to be run by young traders and researchers aiming to make annual returns of at least 8 per cent. And you can now buy into them for as little as £3,500.
As their name suggests, the funds are designed to "'hedge" the risk of making investment mistakes in markets. Their aim is simply to produce absolute returns - to get more back than you put in.
To do this, they adopt strategies betting on different financial or geopolitical outcomes. For example, they might look to profit from decline by "shorting" - borrowing shares to sell in the hope of buying them back later at a cheaper price. Others might pounce on price movements between commodities such as sugar or cotton. Or they might buy shares in both Vodafone and Orange to cover themselves against poor individual company performance but still benefit from a general uplift in the telecoms sector.
Traded offshore in countries such as Bermuda, many hedge funds can only be bought in dollars, although the FSA is con- sidering ways to make it easier for UK companies to set up similar operations.
While they may sound complicated, the case for hedge funds is straightforward, says Mr Turton at Bestinvest. "The problem is that most people are scared of them. But if you buy them as part of a portfolio - perhaps as a fund of hedge funds - to counter the risk of pure equity investments, they do have a place."
Such an investment must be considered with great care, though, as costs can be prohibitive and each fund's approach to risk is difficult to pin down. Be prepared for three tiers of charges: an initial fee to buy in; annual management costs; and performance fees that can be up to 20 per cent of any profits. "High-performance funds will have high performance fees. Investors need to check all these costs," says James Higgins, a director at broker Chamberlain de Broe.
It can cost as much as 5 per cent of the amount you are investing to buy into a hedge fund, but if you use a stockbroker or specialist IFA, expect to pay no more than 0.75 to 1.5 per cent. Annual charges should be around 1.5 per cent.
Many funds have exit dates only once every three months, or less, and there may be currency risks and extra penalties too. "Three months is a long time to wait, particularly if your money is in another currency," warns Mr Higgins. "Witness the recent fall in the dollar."
Exactly how many hedge funds are in existence is debatable but Mr Higgins believes the figure is close to 4,000. Earlier this month, Thames River Capital launched Hedge+, which required a minimum investment of £3,500. It has already closed to new investors, although you can still invest by purchasing shares on the stock market. The fund invests in other hedge funds and aims for 8 per cent growth a year.
So you think you'd never invest in these products?
Hedge funds can seem an alien concept for investors seeking a simple, transparent product, yet some employees may already have savings in them. Occupational pension schemes might invest in the funds, for example, if they fit the mandate of the scheme's trustees.
However, a pension fund needs reliable income to be able to pay out to past staff and build up reserves for current workers. This clashes with the unpredictable nature of hedge fund performance. What's more, as the funds are based overseas and use derivatives and other opaque investments, they are often too risky for trustees. Sophisticated investors planning for their retirement with a self-invested personal pension can also buy into them.
The FSA has looked at making it easier for hedge funds to be set up here, but tax and income complications are delaying the process. A question mark also hangs over the behaviour of some hedge fund managers, with US and UK investigations continuing into allegations of profiteering at the expense of savers.