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The hedge of reason

I have just inherited a lump sum, for which I have no immediate need. Where can I invest to get real returns? I already have a balanced portfolio of shares, bonds and equities.

Why invest? As you know, the main purpose of investment and financial planning is to create financial independence. This is when you own the properties in which you live and have guaranteed income after tax that is greater than your budgeted expenditure.

Having protected your finances should you die, become disabled or incur a critical illness, it is important that your assets are invested in a tax-efficient manner to create spare income or capital.

This applies in the short term should anything happen to you and over the longer term to ensure you live comfortably in retirement.

An individual&#39s tolerance to risk varies based on the time period of the investment and how speculative he or she wants to be. It is normally sensible to use lowor no-risk investments such as cash over short time periods due to the volatility of the investment markets.

Over the longer term, many people take a balanced attitude to risk to make profits without facing the risk of their investment reducing substantially. To achieve long-term real returns, it is necessary to invest in asset-backed investments such as shares and property. However, as you know from the last few years, the value of shares can decline in value, as can property.

There are four main classes of investment – cash, bonds, equities and property. There are various investment products that are a combination of the main asset classes.

When adding to your portfolio, as well as purchasing the right assets, it is important to maximise the tax-efficiency and security of your investments. I assume that you are familiar with the popular collective investment scheme structures such as unit trusts, Oeics and investment trusts.

A type of investment vehicle that has become more popular over the last 10 years is the hedge fund, which can be an extremely useful tool for achieving better risk-adjusted returns. This happens because the fund manager can combine uncorrelated assets.

Most traditional funds will provide returns that are correlated closely with the movement of the stockmarkets invested in. The benefit of a hedge fund is that its value does not need follow the movement of the assets invested in. Often, these funds have target investment returns and strict risk controls.

Within a hedge fund, the investment manager not only has the ability to buy equities and property investments but also sell them without having owned them in the first place. This gives the manager the ability to take advantages that can arise from time to time in the markets. Some of the world&#39s leading fund managers are leaving traditional investment firms to set up their own hedge fund operations as they believe hedge fund management requires more skill and they can make money both in rising and falling markets.

Hedge fund managers can sell short when they think a stock will drop in value. They “borrow” the stock, sell it and then repurchase it when the price has fallen, thereby making a profit. For traditional collective investment schemes, the manager must buy long, that is, they buy a stock and hold on to it with a view that the price will rise over time until it is sold.

Some believe that hedge funds are an asset class in their own right and they undoubtedly can form part of an experienced investor&#39s portfolio. When investing, check if there is an initial charge or simply a performance fee paid to the manager as this can prove to be cheaper. The entry level may be through fund-of-funds hedge funds, which have existing for over 30 years. Over time, it can be illustrated that multi-managed hedge funds have delivered the same returns as global equity markets but with one-third of the volatility, remembering the past performance warnings.

There are many other alternative non-correlated investments which can return profits from unpredictable markets, such as exchange traded funds, which became available in the UK three years ago, and contracts for difference, which allow investors to go long or short on stock by trading on the margin. The use of derivatives offers the experienced investor a way to make profits from volatile markets, remembering that in some cases the risk to capital can be greater than the original investment.

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