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The cutting hedge

Should hedge funds be the sole preserve of global financiers such as George Soros? IFAs traditionally use conventional unit or investment trusts but a few are starting to experiment with low-risk hedge funds.

Hedge funds seek to produce absolute returns, adjusted to bear the lowest risk possible for the target return. Traditional unit and investment trusts measure progress in relative terms, comparing performance with a market index.

If they follow the index down, then they have done a good job. Traditional funds quite often take on higher risks than should be the case to beat their benchmark index.

Hedge funds seek to achieve superior risk-adjusted returns by using futures, options and other strategies to minimise the portfolio.

Hedge fund managers typically get the major part of their compensation through performance fees. Regardless of market conditions, no return, no performance fee. This clearly aligns the fund managers&#39 motivation with that of the investors in the hedge fund to make money.

London firm Sabre Fund Management, a specialist in this area, recently announced an initiative to promote its multi-manager hedge fund to IFAs. It aims to educate and inform IFAs that hedge funds are not all high-risk, vola tile investments which should be avoided at all cost. Sabre aims to show IFAs that this is an investment medium that should be considered by SSASs, Sipps and any balanced portfolio.

One the most successful investors in this area is George Soros. His flagship fund, the Quantum fund, has produced an average annual return of over 30 per cent since inception in 1969. The fund can be considered a higher-risk hedge fund but its returns have been exceptional.

Many IFAs will connect Soros with sterling&#39s spectacular exit from the exchange rate mechanism in 1992. This has added to the whole mystery surrounding hedge funds.

Many hedge funds are set up in tax-free offshore areas where gearing and short selling is permitted within the fund. Onshore regulators allow pooled funds only very limited scope to use these valuable strategies.

Until this changes, hedge funds will remain offshore vehicles and classified as unregulated collective investment schemes for the purposes of the Financial Services Act 1986.

IFAs are permitted to talk to existing customers about unregulated collective investment schemes in accordance with the Financial Services (Promotion of Unregulated Schemes) Regulations 1991.

Pages 291 and 292 of the PIA rulebook provide a useful guide to this area. Most IFAs regulated by the PIA obtain permitted activity 7(b) which allows "advising on and arranging deals in units in collective investment schemes (regulated or unregulated) and shares in investment-trust saving schemes as an independent adviser".

Clearly, this permitted activity is required to promote an unregulated collective scheme but most independent advisers already have the permitted activity in order to promote unit trusts and investment-trust saving schemes.

Hedge funds offer real diversification because, generally speaking, they offer returns which are uncorrelated to traditional stocks and bonds and can act as a hedge against the possibility of falling equity and capital markets.

Private investors, pension funds and even insurance companies should be looking to diversify. In the US, this type of investment is more widely accepted and forms part of an overall portfolio of traditional and non-traditional styles.

For IFAs looking at this market for the first time, a multi-manager or fund of funds approach is sensible. This strategy and fund structure should potentially give prospective investors consistent returns with low volatility.

A typical multi-manager fund will have some 20 managers working on different strategies in different areas. These funds provide an efficient and effective way to achieve diversification across markets and trading styles which will give an investor the chance to achieve positive returns even during periods of turmoil and retrenchment.

Fifty years ago, equities were considered by pension funds to be risky investments. Now equities are viewed as much less risky and form a big proportion of such funds. It may take time but the hedge fund march has begun.

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