Hedge Funds

Hedge funds is a collective investment vehicle that operates free from regulation, allowing it to take steps in managing a portfolio that other fund managers are unable to take.

Hedge funds are collective investment vehicles that admit only a small number of wealthy individuals or institutions. They are free from most types of regulation designed to protect investors, being created either offshore or as private investment partnerships. To place your money with a hedge fund you are generally expected to have a net worth (excluding main residence) of at least £600,000 and to be prepared to commit hundreds of thousands of pounds to the fund.

Originally, the word 'hedge' made some sense when applied to these funds. They would, through a combination of investments, including derivatives, try to hedge risk while seeking a high absolute return (rather than a return relative to an index). Today the word 'hedge' is misapplied to these funds because they generally take aggressive bets on the movement of currencies, equities, stock markets, interest rates, bonds, etc. around the world. They frequently add to the risk by borrowing a multiple of the amount put in by the wealthy individuals or institutions.

The freedom from regulation is a major selling point for hedge funds as it means that they are not confined to investing in particular classes of security, or to particular investment methods. For example, they are free to go short (selling shares they don't own in the expectation of buying them back at a lower price later) which they wouldn't be able to do in many regulated environments. They can borrow 10 times the size of the fund to take a punt on small movements in currency rates. They can buy the bonds of distressed companies selling at bombed-out prices. Some are active in the share index futures market, the short-term interest rate future market and a range of other highly specialized markets that traditional domestic investment funds are much more cautious about entering.

Their freedom to jump in and out means that hedge funds often get the blame for destabilizing markets by moving billions from one part of the globe to another, or from one instrument to another. For example, George Soros came under attack after reputedly making $1 billion by betting against sterling in 1992. Hedge funds were also an easy target for politicians in East Asia in 1997 as currencies collapsed and stock markets fell, leading to economic slow-downs. While it is true that hedge funds can move vast sums around the world - they have $650 billion under management and have access to hundreds of billions more by borrowing - more often than not financial crises are caused by poor economic policy. The hedge funds are on the lookout for governments trying to defy economic gravity and then take advantage of the situation.

Recently the popularity of hedge funds has boomed as stock markets have fallen. They have attracted new interest because of the drive to produce positive absolute returns. Onshore fund managers too often pat themselves on the back if they produce a negative return of 15 per cent while the market fell by 16 per cent. Hedge funds are seen as different in that they are not content with negative performance. Another attraction is that the investments and markets they enter frequently have a negative correlation with domestic equities - an attractive proposition in a declining equity environment market. Bear funds take this idea a stage further. They are designed to do well when equities are falling. They can do this by going short on specific shares, by shorting a stock market index or by selling stock index future contracts.

If the hedge fund does well the managers receive exceptional rewards. A typical fee structure might be 1-2 per cent of the fund value regardless of performance; on top of this 10, 20 or 25 per cent of any generated profits are taken by the managers.

It is impossible to state where hedge funds as a whole sit in the risk-reward spectrum. Some are managed to be relatively safe, while others are dedicated to extreme actions in obscure corners of the financial world. Some have outperformed the FTSE 100 index while many have failed completely (only 60 per cent of those in business 5 years ago are still operating). Performance statistics are sketchy at best, and often downright misleading. One of the major risks investors have largely ignored is the lack of transparency about where their money is being used, which makes it difficult to assess how the fund would survive extreme and unpredictable markets. There is also a greater vulnerability to fraud due to the opacity of funds and absence of regulations. Moreover, there are now over 3,000 hedge funds to choose from and there is a fear that there simply aren't enough talented (and honest!) managers to go round.

The Financial Services Authority has barred most hedge funds from being marketed and sold to UK retail investors. The only way into hedge funds for small investors is via funds of hedge funds, which invest in a range of hedge funds. Some of these are listed on London Stock Exchange as closed-ended investment companies or OEICs.

Critics point out that in buying fund of funds you end up paying two management charges and there is little evidence that managers of funds of hedge funds can consistently select the future best performers. Hedge funds are only for the seriously wealthy, and even then it does not make sense to devote more than 10 per cent of assets to this type of investment.