Hedging against a fall

Investing in supposedly higher risk hedge funds looks set to take off in the UK, despite a warning from the Financial Services Authority (FSA) that many ordinary investors could get their fingers burnt.

But some independent financial advisers (Ifas) say hedge funds offer real potential for those aiming to understand the way they work and the risks involved. Hargreaves Lansdown, a Bristol-based Ifa, believes hedge funds are set to become even more mainstream in 2001 and could well be the success story of the year.

Head of research Mark Dampier said: "Hedge funds are well established in the US and are also taking off in Germany. The problem in the UK is that the level of financial awareness is so abysmal. Yet many investors in hedge funds are receiving returns of 12 to 14% and, in some cases, higher levels."

You won't see much advertising for hedge funds as they are not regulated. The FSA said there were dangers in investing in "exotic" sectors and head of consumer relations Christine Farnish said: "Hedge funds can be difficult to understand, and costs and charges may not be clear and inappropriate for most people." The concern with offshore funds is there is more scope for fraud and less protection.

But while hedge funds were once the preserve of the very rich, it is now possible to buy a piece of the action with a smaller investment. This is because access to hedge funds is now available with a minimum investment of about ?5,000 and can also be bought through an Isa. In the past, a minimum investment in US dollars was required, typically of at least $250,000.

The FSA objects to hedge funds because they are based offshore and because they invest in derivatives such as futures and options. Beyond this, they also have greater flexibility and can invest in other areas such as commodities, bonds, or mortgage or credit card loan-backed securities.

Mr Dampier said while he understood the FSA wanted to protect consumers, the reasons why returns were better were because hedge funds were unregulated and so able to take higher risks and use less conventional methods.

HSBC Republic, the international private banking arm of the high street bank, is one of the latest providers to offer hedge fund products. And the hedge fund, European Absolute, can be placed in a tax-free Isa wrapper. This has adopted the "fund of funds" approach commonly being used by most fund managers aiming at a wider market and means it will invest in between 20 and 30 hedge funds in Europe and the UK. The minimum investment is ?5,000 and the offer closes on 5 April.

WHAT ARE HEDGE FUNDS?
Hedge funds are offshore investment vehicles that aim to make money no matter what the market conditions. They use a variety of techniques to take advantage of difficult situations and, in general, last year outperformed unit and investment trusts. Traditional, regulated investments have been hit hard because of the stock market slump.

They differ from standard funds such as unit and investment trusts by using so-called "long, short" techniques. Traditional funds are long only, meaning they aim to make profits if the value of the stock they hold rises. They cannot exploit falling values. So-called selling short, as used by a hedge fund, means taking a bet on shares the fund manager thinks will fall, putting up the stake and then buying them cheaply.

This potential to profit even on falling share prices is what attracts many to hedge funds. But, it is also high risk - going short means selling stock that is not owned in the hope that it can be bought back at a cheaper price, and so making a profit. Hedge funds also tend to borrow heavily to allow them to place large bets. If the stock that is sold short then rises, heavy losses can be incurred.

There are now a number of well-known names moving into the retail hedge fund market. These include Henderson, Credit Suisse, Deutsche Bank, Morley, owned by Norwich Union, and Matrix Securities.

Henderson, for example, is launching the Henderson Absolute Return Portfolio, or Harp, in April. It has a minimum investment of ?7,000 and can be included in an Isa or Pep.

Hedge funds have been around since 1949 and are based offshore, typically in countries such as Bermuda, but, more recently, a number have been set up in Dublin. The funds are often associated with Hungarian-born US billionaire financier George Soros, who achieved notoriety in 1992, when his Quantum hedge fund began speculating heavily against Sterling, which later meant the currency was ejected from the exchange rate mechanism.

The funds have also had some spectacular nose dives, such as the international bail-out of Long Term Capital Management in 1998, a hedge fund that the US Federal Reserve Bank had to bail out when it was on the brink of failure. The bank intervened because it was concerned about possible consequences for the world financial markets.

But Mr Dampier insists all hedge funds are not the same and some, such as those run by larger and more established names, should not be viewed as high risk. He added that the fact that while it was right that the FSA should be concerned about high charges, hedge funds also rewarded the fund managers differently to standard retail funds.

"It is very much based on performance and while they can earn huge amounts, they only do this if the investors achieve a positive result."

The fund managers of hedge funds also reward themselves differently. In addition, hedge funds could also be used to increase growth among pensions funds. A recent report from the National Association of Pension Funds, which represents the industry, described them as a possible "valuable addition" to the range of options currently available.