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Why hedging needn&#39t be a biggamble

Starting a hedge fund seems to be the latest trend in the fund management industry. Four of the UK&#39s top fund managers have left their jobs in the past fortnight to launch their own funds and there are likely to be more moves before the end of the year.

The attraction has always come from the investment freedom the job delivers. As an unregulated investment vehicle, managers are unrestricted in their strategy and may report to no one but themselves.

But despite the high calibre of most hedge fund managers, few IFAs or private investors follow them to their new funds.

Like venture capital trusts or emerging market funds, hedge funds suffer from an historical association with very high risk. However, few investors are aware there are several different types of hedge fund and, while some provide the highest levels of risk in the market, others offer very high returns with reasonably low risk.

Matrix Securities is drawing up plans for a fund of hedge funds to be launched by Tremont next year. Matrix director Bridget Cleverly says: “If you want high risk in hedge funds, you can get it. But if you want low risk, you can get funds with similar risk profiles to something like a gilt portfolio.”

In an effort to distance itself from the high-risk reputation of hedge funds, Matrix refers to its funds as Alternative Investment Strategy funds.

But other factors have been in play in the slow take-up of hedge funds in the UK. First, no hedge funds are registered onshore in the UK due to regulatory problems. Almost all are based in the Cayman Islands, denominated in dollars and invested in US markets.

This does not put them out of the reach of UK investors but does make them harder to access.

More crucially, because hedge funds are not regulated by the FSA, they cannot be marketed direct to investors. The FSA has been quick to write off hedge funds as too high risk and complex for the average investor, leaving the task of promoting them very tricky for companies such as Matrix. The FSA&#39s official line is that hedge funds are allowed to be marketed to certain IFAs. However, it is unclear exactly who is entitled to invest in the funds and through which channels.

Matrix&#39s new fund will break new ground as it attempts to bring hedge funds to the retail UK market.

Over the coming months, the FSA will be pushed to make its position clearer on hedge funds. With evidence that Matrix is compiling to prove hedge funds are not always high risk, steps may eventually have to be taken to regulate them and open them out to UK investors.

Cleverly believes IFAs will eventually become crucial to the growth of hedge funds and expects to see them become increasingly popular in the UK over the next few years.

The biggest group of hedge funds – the type that the UK&#39s star fund managers are generally starting up – have a long/short equity strategy.

Long/short funds tend to be slightly higher risk but returns are potentially very high. Managers make their money by buying equities they expect to outperform the market, while borrowing equities to sell which they believe will go down. Effectively, these are stock-picking funds, which explains their attraction to unit trust managers.

If one or both of the fund manager&#39s bets are right, the fund will usually make good returns. But serious losses can be suffered if both bets are wrong.

Long/short funds make up around 47 per cent of the world&#39s hedge funds, of which there are currently around 6,000. But some of the less popular types of funds carry far less risk.

Equity market neutral funds, for example, aim to exploit market pricing inefficiencies between pairs of very similar stocks. For example, the manager will select two similar stocks such as BP and Shell, which he believes are outside their historical price spread. He buys the one he believes is underpriced, while selling the overpriced stock, and waits for the spread to close.

These funds are much lower risk than long/short funds but produce good returns. Recent research by Matrix looked at the standard deviations of different hedge funds as a measure of risk. The results show equity market neutral funds to have an average standard deviation of just 3.21, with an average annual return of 14.51 per cent.

To put these figures in context, the FTSE All Share index registers a standard deviation of 11.98, with an average return of 10.93 per cent.

Convertible arbitrage and event-driven strategies are other classes of hedge funds which carry relatively low risk and high returns.

Although most IFAs are yet to get involved with hedge funds, there seems to be an acceptance that things are about to change. Chase de Vere does not currently advise clients to buy hedge funds but is considering a change in its policy.

Investment adviser Justin Modray says: “I think there is a good chance we will start using hedge funds in the next few months. They can be a sensible investment for certain investors and I am sure they will become more mainstream over time.”

If Matrix has its way, hedge funds are on the verge of an image change. In the US, they are already very popular investments, which may be a good indication of things to come over here.

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