How to join the hedge fund club

Anyone following the Northern Rock (NRK) saga may have noticed that, while the headlines tend to focus on figures such as Alistair Darling and Sir Richard Branson, there are a couple of other key players beavering away in the background hedge funds RAB Capital and SRM Global. They may not attract as much attention as the hapless Chancellor or the flamboyant entrepreneur, but as big shareholders in the bank between them they own around 17% of Northern Rock the managers of these funds could scupper the plans of both men.

Indeed, they wield immense power, which lets them scour offers to buy the Rock and then threaten to muster support from other shareholders to block anything they dislike. Meanwhile, other hedge funds have been quietly reaping huge profits by betting on the direction of the bank's share price, which rises every time a new deal for "Northern Wreck" looks to be in the bag, only to fall back as hope fades.

So who exactly are these "lords of havoc", as Janet Bush of the New Statesman describes hedge funds? Are they a force for evil or good? And do they exist solely to enrich a lucky few such as Arpad Busson, the 44-year-old founder of EIM and ex-partner of supermodel Elle McPherson, who enjoys an estimated personal fortune of £250m or can they also offer everyone a profitable route away from more conventional funds?

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What is a hedge fund anyway?

It's tricky to give a specific definition of what constitutes a hedge fund. Lawyers are still struggling to come to an agreed international description and it's hard to point to any household names in the sector as examples.

The best known tend to be those that have imploded spectacularly. Long Term Capital Management (LTCM), for instance, had to be bailed out by the Federal Reserve after some ill-judged bets on Russian bonds in the 1990s. And Amaranth managed to lose $6bn by betting the wrong way on natural gas prices in 2006. With names and sums like that dominating coverage of the sector, it's not hard to see why these funds are shrouded in mystique.

But the truth is, hedge funds aren't that complicated. The key thing to remember is that they are not a distinct asset class, like commodities or equities. They are essentially ordinary investment funds which, because they are based offshore and are unregulated, are able to invest in a wider range of assets and use many more strategies when doing so (see the below for more). They also tend to target an absolute return aiming to make money regardless of market conditions rather than simply trying to beat their sector peers.

However they are defined, hedge funds have certainly arrived with a bang. When American Alfred Winslow Jones set up the first one in 1949, he probably didn't imagine he'd started an industry that, by the end of 2007, would be managing what Hedge Fund Intelligence estimates as $2.5trn of assets or about 3% of global assets under management according to MPC Investors spread over more than 9,000 funds worldwide.

While they were once rather obscure outfits, run for the privilege of a wealthy few, many are now listing shares on popular exchanges. So retail investors can now gain straightforward access to this most-hyped of asset classes. The million dollar question is should you?

The first big difference to note between hedge funds and their bog-standard peers is the fees. Even by fund-management standards, these are astronomic. Although fee structures vary, an annual charge of 2% combined with a performance fee, for the fund manager, of an eye-watering 20% of the fund's returns, is typical.

Many charge a bit more still for the "fund of funds" structure, which is the one most accessible to retail investors. This keeps the fund managers happy (at the 2006 "Hedgestock" festival only an annual income of at least $100m made you a "player"). Investors, on the other hand, should only put up with fees this high for one reason: great returns.

So do they deliver? Well, data from Hedge Fund Research show that 2007 was a pretty good year although you have to take the figures with a pinch of salt, as they only include those funds that survived the past 12 months (a number, including two run by Bear Sterns, didn't). The average fund returned 10%, similar to the S&P 500 with dividends reinvested. But had your capital been in an Asian hedge fund, the average return leapt to above 30%, with energy and technology following at around 15%.

Much of this is purely about being in the right place at the right time most conventional funds in these sectors did pretty well last year too but the more aggressive funds use two main weapons to boost returns. One is derivatives, which many conventional fund managers are now able to use but don't out of fear or ignorance. A derivative (ie, a future or option) allows a manager to make £2, or even £10 from every £1 change in, say, a share price, but at the risk of suffering big losses if things go wrong.

Many hedge funds also borrow capital to enhance returns (just as a big mortgage helps a homeowner to increase the equity in their home as long as the market rises). Aggressive borrowing can, of course, also go wrong if you invest £25m of your own capital and £75m of someone else's in shares, it only takes a 25% drop to wipe you out.

Some of the more exotic hedge funds take things a step further, using "arbitrage" a technique that exploits short-term pricing oddities between related, or even identical, assets (for other common strategies, see below). As a simple example, a friend of mine used to buy VW Golfs in Spain, ship them to the UK and sell them here. It worked until other people copied him and the manufacturer cottoned on and closed the loophole.

Similar anomalies can arise in financial markets across many different instruments, although exploiting these often tiny differences requires speed and plenty of attempts (lots of capital, in other words) for a decent return. Spotting them in today's highly competitive market also requires the help of sophisticated "black boxes", or "quants", capable of screening swathes of data in seconds. The requisite programming talent can be costly and is often poached from big investment banks.

Lastly, unlike conventional funds, who are usually hostages to "asset allocation" (for example, having to keep at least some money in equities in good times and bad), many hedge funds claim to offer "capital preservation" instead. During the equity bear market of 2000-2003, a lot of hedge funds still managed to make a positive return simply by switching out of shares and into assets such as cash and bonds while other funds were losing their shirts.

It's easy to mistake luck for skill

Sadly, the fact that up to half of all hedge funds fail in their first five years, according to a study from the Massachusetts Institute of Technology, shows that this level of freedom is a double-edged sword. As Amaranth showed, many "directional funds" seem wrongly to equate "skill" with pure risk. Far from being hedged against market movements, they take straight bets on which way a given asset will go. As cynics note, the temptation can be for hedge-fund managers to err on the side of risk they'll make huge bonuses if their gambles pay off, but the same bonuses aren't paid back to clients if the bets go wrong.

Also, although many hedge funds have done well from emerging markets, energy and technology this year, so has everyone else, some just using exchange-traded funds at a fraction of the cost. While hedge-fund pioneers enjoyed huge "first mover" advantage and could recruit the best brains, today's massed ranks of hedge funds can't all have "alpha" as Chris Mansi of Watson Wyatt observes, eventually you run out of talent, or new strategies, or both.

That said, you shouldn't dismiss hedge funds. The focus on absolute return should theoretically stand them in good stead in more volatile markets, and they do give retail investors access to strategies such as shorting and arbitrage. But it's vital to be selective. Fortunately, Tim Price has done the hard work for MoneyWeek readers already see his tips below.

Six great hedge funds to buy now

One of the more frustrating aspects of hedge-fund investing is access. Many of the industry's best funds are now closed. Even high-quality funds that remain open often carry minimum entry levels that are beyond all but the wealthiest private investors.

Happily, there is a solution: the closed-ended fund of hedge funds. These vehicles are less exclusive' than classic hedge funds, but they're also more diversified and so carry less manager-specific risk. As they are listed on the London Stock Exchange, they neatly address the issue of entry levels the minimum investment level is simply the price of an individual share, and you deal through an ordinary stockbroker.

Closed-ended funds also address the issue of liquidity. While mainstream hedge funds often lock-in' their investors' money for anything up to a year or more, shares in most exchange-listed funds are bought and sold every day. Better yet, if investors sell their holdings, this does not directly affect the fund manager if sellers outstrip buyers, then the share price simply falls. That means a closed-end fund has less risk than a traditional hedge-fund manager of being besieged by nervous investors and being forced to sell otherwise profitable (or perhaps illiquid) positions a problem which faces the commercial property market right now. The flipside is that the share prices of closed-ended funds, like investment trusts, can and do sometimes trade at a discount to the fund's underlying net asset value.

There are over 20 funds of hedge funds investing in third-party funds listed in London, and several others that either invest with affiliated managers or constitute individual hedge funds. Of the latter, Aim-listed RAB Special Situations (RSS LN) is probably the highest profile. It's also volatile, with manager Philip Richards known for taking aggressive positions in junior miners and, more recently, in Northern Rock.

Another well-regarded single manager fund is Brevan Howard's BH Macro Limited (BHMG LN), a feeder fund for the Brevan Howard Master Fund Limited, which invests across the fixed income, foreign exchange, equity and commodities markets. Between March 2007 and the year-end, its shares returned over 28%.

Of those funds of hedge funds that invest in external managers, some of my favourites include Absolute Return Trust (ABR LN) and Invesco Perpetual Select Trust (IVPH LN), both advised by Fauchier Partners. Remember that what you're really buying with these funds is the ability of the investment adviser to select (and replace when necessary) high-quality hedge-fund talent.

Absolute Return Trust targets a return of three-month GBP Libor + 5% over a rolling five-year period, together with low volatility. Invesco Perpetual targets a return of three-month GBP Libor + 6% with the same objectives. For 2007, Absolute Return hit its target, with the shares returning just over 24%; while shares in Invesco Perpetual Select did even better, returning almost 35%. Past performance, of course, is not necessarily indicative of future returns.

Another multi-strategy closed-end fund of hedge funds worth considering is Altin AG (AIA LI), listed in both Switzerland and London, which saw a 2007 return of over 27%. Altin is priced in US dollars and aims to generate consistent absolute returns, with lower volatility than the stockmarket. It's managed by Alternative Asset Advisors, a member of the Syz & Co banking group in Switzerland.

Finally, the grandaddy of the sector is Dexion Absolute Limited (DAB LN), a Guernsey-registered, London-listed company, advised by Harris Alternatives of Chicago. Dexion raised an extra £460m in December, making it the world's largest listed hedge fund, with assets of roughly £1.3bn. The fund was originally launched in December 2002. Last year its shares returned over 14%. For more details of closed-ended investment companies, see The Association of Investment Companies.

Tim Price is Director of Investment at PFP Wealth Management. He also edits The Price Report investment newsletter.

How hedge funds make their money

US firm Hedge Fund Research, whose indices are used by banks such as UBS, currently lists 37 major hedge-fund investment strategies. The following are among the most common.

Equity long/short

This category mirrors some of the activities of traditional equity fund management. Long/short funds aim to hold good firms and sell short poor performers to profit from falling prices.

Equity market neutral

These aim to maintain an equal and offsetting number of long and short positions. This should protect the manager from a "systemic" collapse in stock prices, while money can still be made from the extent to which long positions in some shares outperform short ones in others.

Distressed securities

These managers buy stocks or bonds in troubled firms, such as Northern Rock, aiming to get a better price following the subsequent liquidation or reorganisation.

Convertible arbitrage

A convertible bond can be switched into a fixed number of shares in the same company at a future date. A hedge-fund manager who believes the bond is currently cheap might buy it and simultaneously sell the underlying shares short before others spot the mispricing.

Event driven

The corporate "event" can be anything from a merger or acquisition to a reorganisation or share buyback. So in "merger arbitrage" a manager might buy shares in the target and sell short the predator, as a takeover is often flattering for the target but expensive for the buyer.

Macro driven

The trick here is to predict how big economic and political events will affect asset values (for example, the turmoil in Pakistan saw a spike in the oil price), and invest accordingly.

Volatility driven

Here the goal is to profit from a change in volatility itself. Individual equity options tend to get more expensive as volatility rises; they can also bet on the direction of an index, such as the Vix, which measures changes in volatility across groups of similar options.