Are hedge fund managers worth the money?

If you live in London and like to shop you should thank God for hedge-fund managers. Why? Because one way or another they finance most of the fashionable little boutiques where you do your shopping.

From Ledbury Road to Westbourne Grove, to the smarter areas of Fulham and Parsons Green, the streets are lined with little shops selling 15 dresses and a swimming costume each.

The uneducated eye might wonder how they make money. There's a simple answer to that - they don't. But that doesn't matter because the hedge-fund managers (sometimes husbands, sometimes friends, sometimes over-eager 'business angels') don't mind. They just like the idea of 'being in fashion', and if going for a touch of glamour on the side costs them £50,000 to £60,000 a year, well, on their incomes, so what?

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So London's shoppers get more shops and access to more designers from more places than they ever would otherwise - often at excellent prices.

But that's not the only thing we should be thanking hedge-fund managers for. Next up is the wonderful stories they provide the press, with the awe-inspiring salaries and bonuses and the fantastic size of their yachts and estates.

Now you, too, will be able to contribute to those bonuses - and hopefully make some money for yourself. Last week, the Financial Services Authority said it would be offering regulatory safeguards to private investors in hedge funds.

But most importantly, we need to thank hedge funds for bringing the concept of absolute returns into the mainstream. Until five or six years ago it didn't matter if fund managers made or lost money, as long as they made a little more or lost a little less than the overall market. All they had to do was look at what everyone else was buying and make sure their returns were the same as everyone else's by buying the same stuff.

Hedge funds, on the other hand, claimed their aim was to make positive absolute returns for investors, regardless of what was happening in the market. This was seen as feisty stuff but, as the popularity of hedge-fund investing has risen, mainstream fund groups have been forced to admit that trying to make money is a reasonable approach to money management.

As a result they have introduced a variety of funds that attempt to do the same.

As well as all the usual dross of funds linked to benchmarks, we now have a few absolute-return funds as well as 'focus funds', which hold only a small number of stocks in which their managers strongly believe.

Hedge funds have been responsible for introducing an element of competitive accountability into the mainstream business, and that is no bad thing.

So it is with concern I note that the days of the obscenely highly paid hedge fund manager may be numbered. Why? Because it seems they aren't that good at their core task. Good at getting personally rich, yes. Good at making absolute returns regardless of the movements of the market, no.

When the Japanese market wobbled last month, falling 7% in three days, I asked a few hedge-fund managers how they had coped. All made considerable losses, in many cases more than the market itself.

The performance of the sector as a whole isn't particularly encouraging either.

This year's Barclays Capital Equity Gilt Study reminds us that hedge-fund managers aren't offering investors much more in the way of returns than your average index fund; the Credit Suisse-Tremont Hedge Fund index has performed pretty much in line with the S&P 500 for a decade or so, and over the past year the average hedge fund returned only about 7% as measured by the MSCI Hedge Invest index; the MSCI World Equity index rose more than double that.

And even that unimpressive performance may be exaggerated, thanks to the way the figures are compiled. Hedge funds don't have to report their returns to the index compilers, so those that have done badly often don't get round to it. This bumps up the average performance figures for the asset class.

I am certain there are some managers who do beat the market on a regular basis over the long term. It's just that there aren't many of them, and there certainly aren't enough people capable of making annual absolute returns to sustain an industry growing at the rate this one is.

The lesson? There are two. The first is that if you are going to invest in hedge funds you should choose one with enormous care. The second is that you should pay as little as possible in fees. Note that the CSFB/Tremont index is calculated after fees, so it is possible that the sector is capable of outperformance it's just that if there is any it is all being eaten up by the fees that pay for the yachts and the shops. Hedge-fund managers tend to charge annual fees of 1.5% 2% as well as taking 20% of any returns.

The good news is that if the funds continue to fail to make real money for investors post-fees, they are going to have to drop their ridiculous charges to survive - shifting some of the extra into investors' pockets.