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How hedge funds work

Michael Clarke, This is Money12 July 2006Deals

THE influence of hedge funds over the City has grown as quickly as investors' money has

flowed into the funds over the past 15 years.

UP OR DOWN: Hedge funds can make money regardless of which way the

market is moving

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These funds now reportedly manage over 750bn of clients' money and their highly-paidmanagers can achieve remarkable returns.

Retail investors have so far been barred from investing in the funds, but that could change next

year. But what are these funds and what makes them so different to normal collectiveinvestments? Read our report to find out.


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What is a hedge fund?

Hedge funds are collective investments that aim to make money whether the market is movingup, down or sideways. Unlike unit trusts, Oeics or investment trusts, which tend to only grow

when shares rise, hedge funds can make money when share prices are falling.

They do this using a range of complicated specialist techniques. The most commonly used is bygoing long or short on a share. Most private investors simply go long on a share, buying it in the

hope that the price will rise.

Where an investor goes short, they believe that the equity will fall in value. There are two main

ways that hedge funds can do this. The first is by 'shorting' the stock, where the investor'borrows' a stock to sell it, with the hope that it will decrease in value so they can buy it back at a

lower price and keep the difference.

For example, if an investor borrows 500 shares of X company at 10 each, they would then sell

those shares for 5,000. If the price then falls to 8 per share, the investor would buy the sharesback for 4,000, return them to the original owner and make a profit of 1,000.

Another way of taking advantage of falling share prices is by dealing in 'contracts for difference'.This allows the investor to make money on share price movements without actually buying the

shares. ACFD on a company's shares will specify the price of the shares when the contract wasstarted. The contract is an agreement to pay out cash on the difference between the starting share

price and when the contract is closed.

However, hedge funds are not only restricted to equities. They will invest in anything that will

make them a profit, including foreign currency, bonds or commodities. The return achieved by

the fund is likely to be dependent on the skill of the manager rather than underlying economicconditions and that is why they are so well paid.

Can I invest in a hedge fund?

At the moment, hedge funds are only available to high wealth individuals who are prepared toinvest around 500,000 or to professional investors, such as pension funds or insurance

companies. Individual retail investors cannot buy directly into hedge funds as the City watchdog,the Financial Services Authority, is concerned about how the funds are operated and their risk.

Plus, it is unclear whether the hedge fund operators would welcome dealing with a large numberof small investors due to the costs involved.

However, the FSA will launch a consultation next year on whether it should increase the scopeof funds it authorises to include funds of hedge funds. Retail investors still wouldn't be able to

invest directly, but would be able to invest in an authorised collective investment scheme thatwould put money into hedge funds.

Currently, if investors want exposure to hedge funds they can purchase shares in the companies

that operate funds, such as Man Group. It is also possible to buy into foreign funds over the


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internet, although investors cannot expect the same financial protection that they would receivein the UK.

This is Money's fund coverage and advice

Fund tips and advice:PERFORMANCE: Oeics and trustsTIPS: Experts recommend the best on Oeics and unit trusts

FUND OF THE WEEK: The best income funds

ADVICE: Unravelling the funds mystery

ETHICALFUNDS: Investing on a clear conscienceFUNDWATCH: Fund managers' share tips

How risky are they?

Obviously, the level of risk depends on the strategy adopted by the manager, but they are

generally regarded as being higher risk than a normal collective investment. The reason for thisis many funds are 'leveraged', which means that they borrow money to add to their fund ratherthan just using investors' capital.

Because many funds use derivatives, where they bet against the future value of the an asset,

rather than purchasing an asset directly, the funds are effectively borrowing the money. Theresult is that gains and losses are magnified, with some making huge profits, but if things go

wrong the fund can go bust.

Also, because the performance of the fund is so dependent on the skills of the manager, picking

the wrong one can prove costly.

Are they regulated?

The majority of hedge funds are domiciled offshore for tax reasons, but the UK-based managersare fully regulated by the FSA. The FSA polices the market against illegal activity such as

insider trading and market manipulation. In March, Europe's largest hedge fund managerGLGand its former star trader Philippe Jabre were each fined 750,000 by the FSA for alleged insider

dealing offences.

However, the FSA does not regulate the funds themselves and, as a result, the organisations have

developed a reputation for secrecy. For example, firms don't have to disclose their investment

strategies other than to clients, or reveal how they have performed.A

lso, if a fund goes bust,investors don't have any recourse for compensation. And as mentioned before, hedge funds arenot currently among the collective investments authorised by the FSA.

How big is the hedge fund market?

It is believed that there are around 8,000 hedge funds operating globally, managing over 700bn

of investors cash. The majority of funds are located in the US, but London is a growing, and


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important, market for the hedge fund world. It is hard to measure their impact on the financialmarkets, but it is estimated that these firms are responsible for around half of the daily turnover

ofLondon StockMarket shares.

It is also thought that they wield considerable power over mergers and acquisitions due to their

tendancy to buy heavily into takeover targets.F

or example, it was believed that hedge fundsplayed a key role in deciding the fate of the London Stock Exchange when several suitors werebidding for the company earlier this year.

The term first originated in the 1940s after alternative investorAlfred Winslow Jones created a

fund that sold short some stocks, while normally investing in others.

Read more:http://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166#ixz

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