Mark Dampier: Hedge your bets on a stock picker

The Analyst

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My fund for consideration this week is, essentially, an FSA-regulated version of a "hedge fund". Now I don't particularly like getting into the politics of hedge funds, which get an extraordinarily bad press, but I did get a letter from one client recently who described hedge funds as "an abomination". He went on to suggest that they were the root cause of all the problems in the financial sector.

That is simply not true. If anything, the hedge managers who, for example, "shorted" bank shares were the messengers telling the regulators and the politicians that something was wrong. The trouble is that the messenger almost always gets shot for bringing bad news. We should remember that even when the "shorting" of banks was banned their share price kept falling.

Cazenove Absolute UK Dynamic is a new fund that will be run by Neil Pegrum, who has over 20 years' experience and has been running a pure hedge fund for the last four years. This has averaged 15 per cent per annum, which is a quite remarkable performance given the volatility in the markets. The new fund will invest in UK shares with a bias towards medium-sized and smaller companies with around 30 to 60 stocks on each side of the balance sheet (i.e. "long" and "short").

Mr Pegrum adopts a stock-picking approach, a description I find leaves many investors scratching their heads. After all, isn't every fund manager a stock picker? Yes and no. Many managers have a more benchmark-orientated approach and are chiefly concerned with how much above or below the index weighting their investments are.

Mr Pegrum undertakes some 300 company meetings a year looking for ones he believes will do well. He tends to favour those with high barriers to entry and quality management, but then also looks for turning points which could materially affect the movement share price. In looking at shorts – stocks that he wants to sell – he uses the existing investment process, but somewhat in reverse. With those he is looking for stocks that are overvalued, where analyst forecasts might be wrong and where the business might be fundamentally flawed.

The fund will have no constraints in terms of exposure to individual sectors and will not borrow to invest. However, it can have gross exposure up to 300 per cent through a combination of long and short investments although, in practice, the fund's net exposure will not exceed 75 per cent. The overriding aim is to achieve an annual return better than 10 per cent over the long term, which is an ambitious but achievable target.

Clearly there are no guarantees in this world, but it seems to me that for those who want some kind of insurance in their portfolio – perhaps because you are nearing retirement or you just want to limit the potential downside – this is a fund to seriously consider. However, don't look for too long because I believe that Mr Pegrum will limit the size of the fund and will certainly be reviewing it if it reaches £100m.

The only thing about the fund that I don't like is the performance-fee structure, which is 20 per cent of all positive performance subject to a high watermark. It seems to me that, while cash returns are currently so low, we could be paying an extra fee for the manager simply matching cash returns. Performance fees are non-transparent and nor do I believe they align the interests of the investor and fund manager.

I wish, in fact, that performance fees didn't exist but the sad they are an entrenched part of the industry. I always try to consider funds on a case-by-case basis, and in some instances the strength of the investment process and the skill of the manager outweigh the negatives of a performance fee. After all, as in many aspects of life, sometimes you need to pay a premium price if you want a premium product. I will be buying some of the fund myself and expect to hold it through thick and thin for many years.

Mark Dampier is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent