NO-HEADLINE

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The Independent Online
Richard Hills has seen the future of the investment management business. And it lies in hedge funds. You don't know what they are? Well, don't be ashamed. Most people in the investment business don't either.

George Soros runs a hedge fund, and if the term means anything to most people, it means a high-risk fund, domiciled somewhere exotic like Curacao, whose job is to speculate wildly in currencies or commodities with borrowed money. Hardly something that sensible investors want or need to worry about, in other words.

Mr Hills thinks differently. Hedge funds, he declares, are "the last great secret" in the investment business - "a source of stunning performance" that remain "largely unknown and unappreciated by most investors". Every serious investor with a large portfolio should have at least part of it invested in this kind of vehicle. They promise the Holy Grail of the investment world - higher returns for less risk.

Strong words. Well, Mr Hills is in the business. His firm, Argyll Investment Management, is a boutique outfit that sells its clients advice and expertise on how to get into hedge funds. It picks out the best performers and packages them into its own stable of low, medium and high-risk "hedge fund funds". At the moment, you need a minimum of $250,000 to invest, but Mr Hills promises it won't be long - probably next year - before ordinary retail investors will have the chance to invest in a hedge fund vehicle as well.

Sounds too good to be true? Well, I am not so sure. Of course, higher returns for lower risk cannot endure forever. But, having visited Mr Hills last week, I can report (a) that he is no snake oil salesman, but a serious and thoughtful investment adviser: and (b) that he has some convincing data to back his case. He points out correctly, that only a handful of the world's 5,000 hedge funds (under 5 per cent) are actually Soros-like funds, taking huge $1bn bets on movements in the world's foreign exchange and bond markets.

The majority are actually quite different animals whose primary purpose, as their name implies, is not to take on huge risks, but to hedge against it. Hedge funds were invented by AW Jones, an Australian who was the first to discover that you could increase returns in the market substantially by backing your judgement that the shares you like will rise, while laying off the risk that the market as a whole will move against you. (The mechanics of doing so, for example by selling index futures, or shorting stocks, can be awesomely technical, but the principle is clear enough.)

True, all hedge funds are still domiciled in offshore havens where the tax man is encouraged not to call and the regulatory requirements are much less onerous than with conventional funds. They use a lot of gearing and a lot of derivatives. Both their strength and their weakness is that they can and do trade in all sorts of exotic instruments and markets - Russian debt, cocoa futures, you name it. Anyone who invests in them needs to do so with his eyes open about what he is getting into.

But that does not automatically make them spivvy, high-risk instruments. In fact, the recent data points in the other direction.

Not only have hedge funds consistently outperformed conventional managed funds in recent years, returning an average of 18 per cent a year, twice what the market did in the period 1988 to 1995, for example, but most have done so while taking on less, not more, risk than the average fund. If you put say six of the best hedge funds together in "a fund of funds", then as with all diversification, Argyll argues, the risk of loss becomes smaller still.

Most investors, says Mr Hills, are essentially risk averse, not risk seekers. What matters to them is not whether their fund has done better than the market as a whole (the criterion by which most unit trusts are judged), but whether or not investors have made or lost money over the period.

The second defining characteristic is that the fund manager's pay is much more closely related to how well he does each year.

Typically, a good hedge fund manager will receive 25 per cent of any gain that his funds succeed in making over and above the risk-free rate of return available elsewhere in the markets. It is a high price to pay, but one that investors only have to stump up when their fund is in the money. (With unit trusts you pay a flat fee based on the value of the fund, whether it goes up or down.)

It means you are likely to get the smartest money managers working for you. The rewards for them, if they deliver, are potentially huge - Mr Soros does not make $500,000 a week for nothing. But so are the skills required. Investing to make absolute returns every year is by definition much harder than just trying to beat the market, though even that proves too much for 80 per cent of unit trust managers each year.

Over the next few years, predicts Mr Hills, more of the UK's best fund managers will move into hedge funds, bringing smarter investors behind them. Before we know it, a business which for years has endured the image of being a speculators' haven will start to become respectable.

At that point, says Mr Hills, the secret will be well and truly out, and the chances are that hedge fund performance will regress to the mean, producing the same mediocre performance as most unit trusts do now. But, for the moment, the tide is running for those who understand the secret.

In the short term I predict that he will be proven right. True history is not that encouraging. The first great hedge fund bandwagon, in the 1960s, ended abruptly in tears when the market crashed. The difference now is that it is much easier, with the computing power available, to calibrate and measure the risks involved. And the calibre of player entering the game is undoubtedly changing - more brains, and in time no doubt also, more spivs.

Are investors up to the task of assessing the risks more accurately than before? That remains the big question.

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