Grab a piece of the hedge fund action

When you talk to hedge fund managers in London these days, it's impossible not to notice the spring in their step and the smile on their faces. And why not? These are good times in hedge-fund land. It's not just that the industry survived two months of market turmoil in May and June and a major hedge fund blow-up in the autumn and still posted 14% returns, making 2006 one of the best-ever years for the industry. That meant another bumper round of fees and bonuses, but that's no different to any other year. Instead, another reason why there are so many happy faces in Mayfair and St. James's (the spiritual home of the UK hedge-fund community) is that the industry has finally shed its image as a reckless menace to the financial world, bringing mayhem in its wake. Hedge funds have become respectable.

True, not many would go so far as one leading hedge-fund manager who tried to persuade me this week that what he provided was a valuable public service. The world is not yet ready to go along with the idea of hedgies selflessly toiling away for the greater good while merrily trousering eight-figure pay cheques.

How hedge funds won acceptance

Even so, an industry whose members were branded "locusts" two years ago by a German politician is steadily winning acceptance. First, from central bankers, who no longer fret about a hedge-fund collapse triggering a global financial crisis, but now talk about the industry as a force for financial stability. Second, from pension funds and other institutional investors, who have earmarked billions of dollars to invest in hedge funds. Third, and most tellingly, from stockmarket investors, who eagerly bought shares in two hedge-fund managers, Bluebay and Ashmore, that floated last year.

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Of course, beyond the City and regulators, there's still plenty of suspicion about hedge funds. People want to know how come these upstarts can charge such high fees for what often looks like pretty so-so performance. Hedge funds may have returned 14% in 2006, according to Eurekahedge, but that was worse than the FTSE 100, which was up 18%. You could buy an ordinary tracker fund that gave you exposure to these markets and only charged fees of 0.5% a year. Yet a typical hedge fund charges a 2% management fee and 20% performance fee. How do they get away with it?

The attractions of hedge funds

But these objections fail to appreciate what it is that hedge funds are trying to do. The Holy Grail of the industry is so-called "alpha", which means making excessive returns above those of the market. Straight market returns are known as "beta". But generating this pure alpha is very hard. Think how few fund managers consistently beat the index. A true hedge fund must first identify assets it thinks will outperform and then use elaborate hedging strategies to strip away the market risks. At its most basic level, this might involve betting that British Airways has become

a takeover target and is likely to outperform, but shorting the shares in other airline stocks to strip out any share-price movement attributable to the wider airline market. At its most extreme, hedging strategies involve the use of highly complex derivatives that are well beyond the skills of most ordinary fund managers.

Sure, every hedge-fund manager in London claims to be generating alpha, but most probably don't. It's very difficult to measure. Undoubtedly, most fund returns contain more market performance than they would care to admit. But those that can deliver the goods are rare and highly valued by investors hence the very high fees. What these funds offer are absolute returns positive performance regardless of what happens in the wider market. Historically, that appealed to high-net-worth investors who wanted to preserve their capital in the case of a market slump. Increasingly, it also appeals to institutional investors, such as pension funds and insurance firms, who want to diversify their portfolios. They already have large holdings of shares and bonds. What they want are other assets whose performance is not linked to those markets. Hedge funds, like private equity and infrastructure, fits the bill.

How ordinary investors can get involved

Whether hedge funds are appropriate for ordinary investors is another matter. Most are beyond the reach of anybody without very large sums to invest. And few investors have the time or skill to analyse and evaluate the funds available to select those able to deliver on their promises. But private investors have reasons to be grateful for the hedge-fund revolution. All investors benefit from the role hedge funds play in transferring market risks, which has reduced volatility and made it easier for banks to lend. That has been a big factor behind the current boom. Hedge funds also play an increasingly important role as activist shareholders bringing greater focus to the management of public firms, helping them wring more value from their business. And even if ordinary investors can't invest in hedge funds, they can now invest in the firms that run them, through a handful of London-listed companies, such as MAN Group, RAB Capital and Bluebay. This is an industry set for huge growth. Investors should put aside their scruples and demand a piece of the action.

Simon Nixon is executive editor of Breaking views.com