Personal Finance – Gateway of opportunity.

Fancy investing in a hedge fund? Just weeks ago that would have been a daft question for all but the wealthiest investors.

But already this year the situation has changed dramatically. HSBC, Henderson Global Investors and Morley Fund Management have all rolled out hedge fund-type investment products aimed at smaller investors.

All of their deals have been made available to investors inside a tax-free individual savings account wrapper. This means the minimum investment can be no higher than #7,000.

Crucially, hedge funds can, in theory at least, make money even when stock markets are moving sideways, or even downwards.

Of course, many of the new target audience have only a hazy idea of what a hedge fund is.

They were last in the news in 1998, when Long Term Capital Management (LTCM), a hedge fund backed by some of the biggest names on Wall Street, racked up losses of $5bn in five months. Before that, many will remember the antics of billionaire financier George Soros, who used a hedge fund to make $10bn betting against sterling in 1992.

With that track record, why should hedge funds appeal to more risk-averse private investors? Conversely because hedge funds can actually reduce risk.

The discrepancy arises because a wide array of investment vehicles are included under the catch-all term ‘hedge fund’.

Soros’ vehicle was a Global Macro fund, by some distance the highest risk. In effect, the manager is given the freedom to make huge bets on the movement of economic indicators, such as currency and exchange rates.

LTCM investors bet their shirt and lost with a Fixed Income Arbitrage fund. These are normally relatively low risk devices used to exploit small differences in the yields offered by gilts and bonds.

But impressive returns are possible, as these funds borrow heavily to invest. When they go wrong, as LTCM did, they can do so spectacularly.

But most of the new hedge funds are of a third breed: long/short funds.

These do two things. Firstly, they buy shares expected to rise in the usual manner, known as ‘going long’. Secondly, they take bets on stocks tipped to fall, or ‘going short’.

They do this by going to the derivatives market and buying a ‘put’ option.

This option gives the fund the right to sell the shares at a fixed point in time for a set price, usually close to the current market price.

If the shares fall in the interim, the fund can buy them for the knockdown price and sell them using the put option – making a handy profit.

The strong point of these long/short funds is that they take the movement of a given index, such as the FTSE-100, out of the investment equation.

As long as the manager gets the individual company call correct – ie share A outperforms share B – the fund will make money, whether the index rises, falls, or stays exactly where it is.

With most major stock markets currently in the doldrums, and few signs of an immediate recovery, this can seem an attractive proposition.

Ravi Anand, director of HSBC Investment Bank, the latest to jump on the hedge fund bandwagon, says: ‘People are looking for ways to make money, even when the markets are going sideways or downwards.

‘Last year the average hedge fund delivered a positive return, against a market that had fallen.’

Most of the new-style hedge funds further reduce the level of risk by taking a ‘fund of funds’ approach. That is, they invest in a series of existing hedge funds, smoothing the gains and losses of the underlying funds.

HSBC’s European Absolute fund, for example, will invest in 20 to 30 existing hedge funds operating in the UK and continental markets. It launches on 9 March, with a minimum initial investment of #5,000.

Henderson, which launches its Absolute Return Portfolio on 19 March will also be investing in hedge funds run by ‘well respected UK-based managers’.

Morley is making matters more complex still with its Morley Absolute Growth Investment Company (MAGIC).

MAGIC, an investment trust, will sink 45% of its assets into other investment trusts. The other 55% will be invested in the Morley Alternative Strategy Fund.

This is an existing long/short hedge fund investing primarily in the UK and Europe. The minimum investment is again #5,000.

But besides the obvious risk that hedge fund managers may make poor calls, there are other downsides. Hedge funds are expensive, which is probably one reason why investment houses are keen to sell them to us. And the fund of funds approach is more expensive still, with the costs of the underlying funds adding to the fees charged by the umbrella fund.

All in all, you can expect to pay around 3% a year for one of these investments.

This compares to around 1.5% for a typical actively managed fund, or under 1% for an index ‘tracking’ fund.

Jason Hollands of independent financial adviser Bestinvest says: ‘They are not cheap, but if they do what they say they will, they will not be a bad investment.’

A second drawback is that hedge funds are not authorised in the UK, and therefore have to be registered offshore. Dublin, the Isle of Man and the Channel Islands are popular destinations.

This is not a problem in itself. But in the event of fraud, investors would not be cushioned by a compensation scheme.

Related reading