So what are hedge funds?
Money Talk
By Robert Brown
Watson Wyatt
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Robert Brown lifts the lid on the once opaque world of hedge funds
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Unlike banks, building societies, insurance companies or stockbrokers, there are no mentions of hedge funds in the Yellow Pages.
And it is highly unlikely you will find one based in your local high street, yet there are a lot of them around - and in some odd places too.
Hedge funds are often linked to takeovers or other big trades in the financial markets, and they are often embroiled in regulatory debates. Hedge funds have become big players.
It has been claimed that these privately owned investment companies are responsible for half the daily turnover of shares on the London stock market.
Industry experts calculate that there are around 8,000 hedge funds operating globally, mainly in the USA, with hundreds based in the UK - primarily in the West End.
But the reason they don't advertise in the Yellow Pages or any other similar directory is that they are not offering their services to the man or women in the street.
Instead they offer their investment capabilities primarily to very wealthy individuals or to professional investors such as insurance companies and pension funds.
Rapid growth
The world of the hedge funds has grown rapidly in the last 15 year or so.
They first sprang up in the USA on Wall Street in the 1940s.
They invest money - in anything that they think will make profits
Robert Brown
At first they concentrated on investing money for the extremely wealthy.
The first time anyone in the UK outside the financial markets really heard of them was when the firm run by George Soros reputedly made hundreds of millions of pounds by betting that the pound would be ejected from the European Exchange Rate Mechanism back in 1992.
The opportunity to make huge sums of money, not to mention looking after their own wealth directly, has since lured many traders and bankers in the City of London away from the big investment banks and investment management companies.
They have set up their own firms, where they can run their own business and generate more of the profits for themselves.
Some of these firms operate from discreet offices, where substantial amounts of money are managed by high-profile investment professionals with long track records in the business.
Others have very few staff, relying on the investment judgement of just one or two people.
Varied strategies
So what do they actually do?
The simple answer is that they invest money - in anything that they think will make profits. Typically they focus on generating positive "absolute returns" (or returns greater than zero).
Hedge funds embrace a wide variety of skills and strategies, generally grouped under the four following headings:
Long/short equity - they aim to profit from superior research and stock picking skills by buying the best ideas and reducing the resulting stock market exposure by shorting (selling stocks they do not own) those they believe will perform less well.
Relative value - typically they use computer systems to calculate the "fair" value of one asset relative to another and then shorting the more expensive asset and buying the cheaper one.
Event-driven - they seek investment opportunities surrounding corporate events, for example, investing in bankrupt or merging companies.
Trading strategies - for example, taking positions on the direction of markets, currencies and commodities.
So, hedge fund managers are essentially a group of active investment managers who invest in a variety of asset classes, with the licence to invest in a very flexible way.
What is so special about them?
The return achieved by a given hedge fund manager will (in theory) largely be driven by that manager's ability (or skill), rather than by underlying economic or market conditions.
So they offer the potential to achieve investment returns with relatively low volatility and largely unrelated to whether a particular investment market (such as shares or bonds) is going up or down.
The main reasons for this are:
Hedge fund managers generally try to remove some market exposure and aim to produce a positive return irrespective of market direction. Often this will involve making an offsetting bet to hedge against losing money on the original investment position.
The unrestricted nature of hedge funds means that the investment managers are able to fully utilise their skill to produce positive performance.
Operating in fairly small areas of the market means that investing in a number of funds can reduce volatility through the benefits of diversification.
One feature often attributed to hedge funds is the widespread use of derivatives; sophisticated bets on the future direction of an underlying asset such as a share, currency, or even a whole financial market.
Some hedge fund managers will use derivatives almost exclusively, such as Contracts for Differences, rather than buying the underlying asset directly.
In some cases a hedge fund may do this to build up a larger investment position than they could afford directly - known as leverage.
The truth though is that the use of derivatives is commonplace in conventional banks, investment banks and other more sober financial outfits such as insurance companies and the treasury departments of big companies.
Easy money?
Despite having a large concentration of investment expertise, hedge funds can still lose money for themselves and their clients, or provide just rather disappointing returns, so choosing the right ones is key.
As noted earlier, the return from a given hedge fund manager is largely driven by the manager's ability or skill.
Some funds simply won't reveal to anyone except their clients what their general trading strategies are, or how well or badly they have been doing
There have been considerable flows of money into this area and increasing volumes of assets chasing the same opportunities may depress returns.
Also, many hedge funds restrict how much money they will take on so they can sensibly manage the funds they already have, and it is not uncommon for the most skilled (and hence desirable) managers to be closed to new investors.
They can charge very high fees, which can be high enough to erode any out-performance achieved by the manager, so due care is advised when selecting them.
Most hedge funds are domiciled offshore for tax reasons. But if the managements who actually run the business are based in the UK then they should be subject to full regulation by the Financial Services Authority.
Overall though, there are considerable risks involved in investing in one or just a small number of hedge funds.
Hedge fund indices
As the interest in hedge funds has grown, a similar trend has developed to copy the mainstream financial markets: the "investable index".
These indices - rather like the well known FTSE 100 share index - allow investors to allocate money across a range of strategies and managers, with the aim of generating returns that match one of the well known indices.
This should also help to shed a bit more light on what has often been a very secretive world.
Some funds simply won't reveal to anyone except their clients what their general trading strategies are, or how well or badly they have been doing.
Others have become more transparent, publishing investment updates, quarterly or even monthly, that anyone can read.
Despite that, an investor needs to decide if an index return is really the right target and whether the managers included are truly representative of the underlying managers in each strategy.
Conclusions
Hedge funds have become an increasingly popular form of investment for professional investors who have diversified away from mainstream share and bond investment.
It should be noted, however, that they are only one option within an ever increasing range of investment strategies.
Their place should be considered alongside other alternatives such as private equity, property and commodities.
The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.
