Hedge funds have been the black sheep of the stock market in the past month, accused of exploiting share-price weaknesses and causing markets to lurch up and down through their obscure investment tactics. But the Financial Services Authority is now putting the feelers out to see if private investors hunting good returns want to get in on the act.
Chief executives of FTSE-listed companies, such as David Prosser at Legal & General, who have seen their share prices decline steeply have been railing against the strategies used by hedge-fund managers. These usually involve the practice of short selling, which involves borrowing stocks to sell in the hope their value will go down. Managers buy them back more cheaply later on.
But while institutions may not like the idea of hedge-fund managers borrowing their shares to gamble with, private investors can use hedge funds to achieve good returns that are not correlated to index movements. The managers say stock markets can be inefficient and there are opportunities to exploit mispriced shares. The funds use borrowings to obtain a higher- than-normal profit on equity investments and short-sell some stocks to insure, or hedge, against a market downturn.
Instead of trying to achieve a relative performance against a benchmark, hedge funds aim to achieve steady, absolute growth. Their performance is not correlated to equity, bond or currency markets, meaning they have enjoyed good results over the past few years compared to normal equity funds. Hedge funds are not directly available to private retail investors in the UK. A minimum investment of pounds 100,000 is standard which has put hedge funds out of reach of most ordinary investors.
The FSA this week said it was unlikely to tighten regulation of hedge funds, but it is keen to find whether there is scope to make hedge funds more widely available. It is asking fund managers and potential investors if they want more freedom to invest in hedge funds.
Michael Folger, a director at the FSA, says: "The hedge fund market has grown significantly, as increasing numbers of wealthy investors and trusts have decided to place a proportion of their portfolio in `alternative' investments."
Patrick Connolly, a director of the independent financial adviser at Chartwell Investment Management, says investors are interested in diversifying their portfolio from the traditional mix of equities and cash. "We are seeing more interest in property and corporate bonds, so there should be a big interest in hedge funds because their performance is not directly linked to markets, which is good at times like these.
"But as yet, clients are not interested because they don't understand how they work. If they were more widely available and open to people with less than pounds 100,000 to invest, there would be more interest. But it will be a slow process."
Anyone wanting to invest in a hedge fund can do so through a financial adviser who must be convinced the investor understands the risks involved. This in itself has been a barrier, because advisers themselves are not often experts in intricacies of how hedge funds work, and have been unwilling to learn.
"You need to be a specialised adviser to take on these types of funds," Mark Dampier, head of research at independent financial adviser Hargreaves Lansdown, says. "There is a huge lack of understanding by advisers and so they haven't been keen to promote them to clients. Some of this stuff makes rocket science look easy. Although the strategy of shorting stocks is the most well-known, there are six or seven ways of hedging. Short selling can be tricky; if the manager gets their position wrong, the problem can become significant. Hedge funds don't always go up. …