Hedge Funds: Look out for hidden charges

One of the main ways in which hedge- fund managers justify their exorbitant fees is by arguing that their methods give them greater opportunities to beat the market. But a recent study by Roger Ibbotson and Peng Chan of researcher Morningstar reveals that investors often don't get what they think they are paying for. The Lipper Hedge Fund Database shows that the sector has returned a seemingly impressive 16.5% a year (after fees) between the end of 1994 and April 2006, ahead of the 11.6% average annual gain for the S&P 500 over the same period.

However, the database does not cover hedge funds that have done so badly they have shut down (1,071 since 2005, says Hedge Fund Research). The results are also skewed by the fact that they are far from comprehensive. Hedge funds are not obliged to report numbers publicly, so if their results present them in a bad light they very often just don't, something that leads to a systemic positive bias. After adjusting for these factors, Ibbotson and Chan reckon that hedge funds have, in fact, returned only 9% a year.

This is depressing news for all hedge-fund investors, but should make small, private investors particularly wary: hedge funds of funds the only really practical way into the sector for such investors impose their own charges on top of the ones already set by individual hedge funds, something that eats into returns even further.

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A risky way to cut IHT

Those who want to avoid inheritance tax (IHT) can now benefit from tax breaks on farmland "at a fraction of the normal cost", says The Sunday Times's David Budworth. The FIM Farming fund (01451-844655) has a minimum investment of £20,000 and aims to take advantage of the fact that qualifying farm owners can get 100% IHT relief once they've held the asset for two years.

But there are some significant catches in the scheme. The IHT relief only applies to working farms, so the farms will be run by management group Velcourt. The trouble is that to qualify for the relief, owners must share in the fortunes of the farm, so if they lose money investors may have to pay up to cover the losses. Also, up to 15% of the fund may be invested in farmhouses, which do not necessarily qualify for IHT relief and you are exposed to changes in land prices. But the main problem is the fees and inflexibility of the fund. The 6% entry charge and 0.6% annual fee will eat into your investment. Money cannot be taken out until April 2010 at the earliest, and then there is a 2.5% exit charge. Those who are wealthy enough to worry about IHT should consider other ways around the tax.