Hedge funds come in from the cold

In little over a fortnight, the Financial Services Authority will publish proposals that hedge funds should be allowed to be sold to small investors. This means that at least some of these funds could be marketed directly to the public, so as early as next year UK-based investments such as unit trusts or open-ended investment companies (Oeics) could provide access to hedge funds for savers putting in as little as £1,000.

The proposals are bound to create a stir. The FSA has been forced to defend plans to relax rules for overseas investment funds selling shares on the London Stock Exchange. The new rules, which would see hedge funds and other offshore firms facing a lighter regime than UK-based equivalents, drew a barrage of criticism. John McFall, chairman of the Treasury select committee, accused the FSA of introducing a 'gaping hole' in the protection given to investors.

In response, the FSA's director of retail policy, Dan Waters, said the proposals were vital if Britain was to maintain its competitiveness, and praised hedge funds for 'reinvigorating' the sector. Nevertheless, they remain controversial. Recent months have seen fierce debate in the EU and US about greater regulation, and the Bank of England has proposed a voluntary code of practice for those that are London-based. Meanwhile, Germany has pledged to use its presidency of the G8 this year to push for greater transparency from hedge funds.

Even the FSA has concerns. Last October, Waters himself repeated warnings that some funds were 'testing the boundaries of acceptable practice'. And just three years ago the FSA rejected a similar move to widen access to small investors, concluding that there was little demand for this from either the public or the hedge fund industry. So why do it now?

'Because they're already being sold to them,' says FSA spokesman Robin Gordon-Walker. As well as being able to buy hedge funds over the internet from other EU countries, investors have access to the shares of a growing number of hedge fund managers listed on the LSE (a number that the new rules would increase). And some investors are referred to offshore hedge funds by financial advisers.

The FSA hopes the rule change will mean more small investors end up in funds over which it has direct control. 'We think if it's going to happen anyway, it should be done in a regulated way,' says Gordon-Walker.

Many in the industry have welcomed the move to greater liberalisation, but worries remain. The first is about risks . Hedge funds have become notorious for their use of leverage - borrowing money to top up their investments. This boosts profits but leaves them open to big losses. Last September, Amaranth Advisors lost $6bn in a matter of weeks.

'The problem is that the term "hedge fund" has been hijacked by a load of gamblers,' says Mark Dampier of adviser Hargreaves Lansdown. 'A traditional hedge fund is all about reducing risk and safeguarding capital. It shouldn't be a highly geared betting fund.'

Hedge funds vary widely, and many argue that they are far less exciting than the media make out. Many funds, for instance, still take the approach that Dampier supports. Investment manager GAM is a good example. It runs one of many 'absolute return' funds, which aim to make money regardless of what share prices are doing. This invests in equities when markets are rising and uses hedge funds to provide modest growth when markets are falling. Similarly, Matrix, an offshore hedge fund manager, offers an 'equity-market-neutral' fund. This aims to provide only 2 to 3 per cent above the return you might get on cash in a year. The attraction is that it says it can do so even if the stock market takes a dive.

Moreover, the FSA is only proposing to allow the marketing of funds of hedge funds (which is what the Matrix fund is). These put money in a number of underlying hedge funds, diluting the impact should any of them lose heavily.

As Matthew Butcher at broker Brewin Dolphin explains, these hedge funds became popular during the 2000-02 stock market falls and are pitched at more cautious investors. 'Most people in the industry would say that investors who can't face losing much money can't afford not to invest in them,' he says.

The other problem with hedge funds is less easily brushed over: they can be incredibly complicated. As well as being able to invest in almost anything (from shares to African debt to feature films) they also use a range of investment strategies, some of which take a mathematics degree to understand. It is telling that although hedge funds have been around for 60 years, there is still no generally accepted definition of what they are.

According to Roger Lawson at the UK Shareholders Association, this could leave small investors open to being talked into investments that will do them little good. 'I don't think most retail investors would understand hedge funds,' he says. 'They'd be sold on the basis that they have a wonderful track record and small investors would get sucked into them.'

A big rise in the number of hedge funds in recent years means there are a lot more mediocre ones around. Furthermore, because retail investors will have to use funds of hedge funds, they also face two lots of fees - one to the underlying hedge funds (normally 1.5 to 2 per cent of the investment plus 20 per cent of any profits) and a similar fee to the manager of the fund of hedge funds. Those going through a stockbroker or a unit trust might even find themselves paying a third layer of fees.

On the other hand, as Hugo Shaw at adviser Best Invest explains, given the relatively modest returns many will promise, hedge funds may struggle to attract smaller investors. But Shaw and others argue that it is worth it, particularly given the recent woes in the stock market. The real danger, they say, is that even those who could benefit from hedge funds may decide ignorance is bliss.

Long and short of it

There are now more than 9,000 hedge funds reckoned to be managing about $1.5 trillion - a growing proportion of it from pension funds and endowments. Most hedge funds are based offshore, with locations such as the Cayman Islands, Bermuda and Ireland all popular. This is partly for tax reasons.

They represent a wide range of strategies, from the global macro funds popular in the early 1990s (which aim to profit from shifts in interest or exchange rates) to event-driven funds, which bet on mergers or takeovers.

Among funds of hedge funds, market neutral and equity long/short strategies are widespread. These rely on 'shorting': the fund borrows assets its manager suspects may fall in value, sells them, and then buys them back later at the cheaper price. The hedge fund should make money if the market falls, although in that case it will be losing money on its 'long positions' - assets it has bought in the hope their price would rise.

The aim is to reduce the risk by giving up some potential profit to hedge against the risk of a fall.