Secrets Of Success: Dismiss hedge funds at your peril

In a recent consultation paper, the Financial Services Authority appeared to be opening the way for hedge funds, or more specifically "funds of hedge funds", to become available directly to the private investor. Is this good news, or are investors going to be put at greater risk from possible mis-selling?

Certainly the innovation of hedge funds has proved very dramatic over recent years, to such an extent that both market-traders and floated companies have to watch carefully how these beasts are behaving. A good example of this lately was the aggression of the hedge-fund manager who was investing in ABN Amro with the apparent aim of trying to break up the business. The result is still as yet unclear but, whatever happens, life at ABN Amro will never be the same again.

Some investors even regard hedge funds as a different asset class, although we regard them as merely a different - and unregulated - way to manage the same asset classes as "long only" managers, but the funds by no means have a single standard structure. In fact, to find a simple definition of hedge funds is well nigh impossible. A quick Google reveals at least 50 variations from astonishingly complex derivatives-based structures to something that look more like a normal "long only" investment-management service. The different styles appear legion, and focus on virtually anything that can be traded. Such structures look for and thrive on volatility to be able to arbitrage positions between prices for their benefit. However, as they move, like flocks of seagulls, from one sector to another, their very number acts to reduce the value of the potential opportunities - the greater the number chasing the limited opportunities means that the breadth and depth of their markets diminishes.

Over the past year we have seen market sectors being "hedged" - including commodities such as oil and gas, (the latter of course which went disastrously wrong for some last year) but also emerging market debt. All seem to become fashion fads until the differences are squeezed out and then the next area is identified and the seagulls move on.

Certainly hedge funds have attracted some significant investment talent, with many of the most successful investment managers being lured by the opportunity for a broader type of investment and, of course, the glittering prizes of enhanced performance fees - or is that just greed? However the talent is not universal, as I have come across some managers who would give two short planks of wood a run for their money in an IQ test.

Nevertheless, hedge funds are a valid form of investment style and cannot be ignored. They vary greatly, not only in their investment style and content but, more importantly to me, in their risk profile. They will vary from the dynamic to the point of fear, through to the very defensive. The key question for the investor is: which is which?

The question of risk is assisted by the technique of having a fund of various hedge funds, which can thus dilute the risk of one single fund amongst others.

Once the issue of the risk profile has been addressed, then investors should try to understand the actual process that the fund operates. That is to say how and in what it is actually investing, and, importantly, with what risk controls it operates under. This is often the excuse for some rather patronising statements that "it would be too complicated" for us to understand and that we shouldn't "trouble our poor little brains" with such detail. But, just tell me what you are planning to do with my money!

Then there are the charges. These can be both varied and imaginative. Annual management fees, extra performance fees (20 per cent is not unknown) and other deductions are all common. No wonder so many people want to run hedge funds - that is until they realise how many don't actually make it. There are roughly some 9,000 hedge funds around the globe, with an average life of four years each - some by design - others not! It is estimated that, last year, we saw the demise of around 400, although this number was outweighed by the number of new entrants.

There is also the question of trading and access to the funds. Sometimes they can trade only on a six- or 12-month basis, which means that you are locked in and can't extricate yourself when you want to. But this does give rise to another issue of trading, in that you will often find that the fund managers are invested in the funds themselves, which is very laudable - that is so long as you can all trade at the same time and that you, as the outside investor, are not left holding the "remnants". With the "fund of fund" structure this is normally much easier.

However, I believe that the greatest area of threat for investors is the question of transparency. In all investments I believe we need to see right through them and to understand what is actually going on wherever possible. The opaqueness of many funds is often covered by the excuse for the need for secrecy about their investment strategy, which I can understand for an immediate trading situation but not really for regular valuations "after the fact".

I must apologise if I sound so negative, when in reality I am not. However, I am very concerned that unwary investors may be lured by the siren calls of commission hungry salesmen into hedge structures that are not suitable for them or their investment risks. It is very easy to lure people into the charms of a secret black box that apparently can create financial magic. But I want to see clear, open, investments in which we can understand the risk, if not all the detail, and not be sold the financial equivalent of the Harry Potter school of investment management

Justin Urquhart Stewart is a director of Seven Investment Management