UK awaits retail access to funds of hedge funds

Date: Monday, July 23, 2007
Author: Ellen Kelleher, Financial Times

The UK regulator shook things up a few months back when it proposed the introduction of regulated funds of hedge fundsthat would give small investors easier access to hedge fund strategies.

But thus far the good news that private investors received from the Financial Services Authority in March has not had much impact on hedge fund inflows.

Managers have shown little interest in marketing directly to the public to attract small sums of cash from a large number of investors, advisers say.And it is institutional investors such as pension funds and insurance companies that still appear most interested in hedge funds.

The Bank of New York predicts that institutional demand for hedge funds will soar from $360bn (€261bn, £176bn) to more than $1,000bn by 2010.

UK retail investors can only invest in offshore funds of hedge funds, or investment trusts traded as public companies on the London Stock Exchange.

Under the rules proposed, which are still subject to a period of consultation, unit trusts and other open-ended funds investing in hedge funds will be allowed to set up in the UK as long as they carry out a proper examination of the risks of the funds in which they put money.

Given the chance, advisers predict most retail investors are likely to favour investing in funds of hedge funds, which tend to be more liquid.

In most cases individual hedge funds are not a good bet for solo investors as the minimum required for investing is usually at least $100,000. Also, retail investors find it difficult to assess the risk of putting money into individual funds.

"In our view, the lack of transparency, generally high explicit costs and high turnover make hedge funds a high-risk investment for non-specialists in terms of the reduced chance of achieving what matters to an investor," says Jason Butler, an adviser with Bloomsbury Financial Planning.

While managers at fund houses are bullish on the FSA's proposal, they remain uncertain about how hedge funds and asset management firms will take advantage of the rule changes. Many insist the development of onshore funds of hedge funds would depend on the Treasury changing the tax regime.

"It's probably too soon to say what kind of companies will dominate this space, but what's critical for asset management companies is that the right tax regime is in place - one that applies to other UK authorised collective schemes," says Celeste Dias, Threadneedle's headof product development.

Some advisers say the likely result will be that more established long-only hedge funds, which only bet on markets going up, will add additional funds for retail investors to their product ranges.

"It seems far more likely that the big players as far as the public is concerned will be those established long-only groups with an existing presence whodecide to add a fund ortwo of hedge funds andhave the infrastructure to support them," predicts Mr Butler of Bloomsbury.

As it stands, private investors buy into hedge-style investments in two ways: LSE-listed funds of hedge funds and long/short Ucits III funds, which permit managers to benefit from falling markets.

Advisers say putting money into funds of hedge funds is sensible, as holding a range of funds spreads risk, and a good manager is best-equipped to spot "diamonds in the rough".The 30 or so listed funds of hedge funds - similar to investment trusts - are becoming quite popular with investors and raised £1.5bn last year.

"The advantage of listed funds is they provide daily liquidity and offer diversification," says Jason Hollands at F&C. On the downside, they suffer from high charges and, like investment trusts, a possible discount to net asset value volatility.

Ucits III funds are less expensive, but there are only a few equity long/short funds to choose from. There is also a greater choice of "target return" funds, which are primarily concerned with fixed-interest investments, but these have largely failed to hit targets to date and remain unconvincing, ac-cording to Justin Modray, an adviser with Bestinvest, the advisory group.

Most analysts say hedge funds are unlikely to explode in popularity among mainstream investors in spite of the FSA's U-turn on policy, due to their high charges.

"At the end of the day, hedge funds are often an opportunity for a manager to make two bets on the direction of all or part of the market - up and down - as opposed to the one of a long-only fund. With the overwhelming body of academic evidence supporting the contention that active management is not a cost-effective way for investors to obtain capital market returns, trying to do this via hedge funds is just an expensive way of risking getting both bets wrong instead of just one," Mr Butler concludes.