Why BT is buying hedge funds

Strategy: Why BT is buying hedge funds - at Moneyweek.co.uk - the best of the week's international financial media.

Private investment funds, usually run for the benefit of a small group of rich investors with at least $1m to burn. Most are registered offshore in exotic tax havens such as Grand Cayman and Bermuda, which puts them beyond the reach of regulators and allows them to operate more or less as they please. That means that hedge funds are free to invest in anything they like, including shares, currencies, commodities and third-world debt, making use of sophisticated financial instruments, such as futures, options, swaps, short selling and high leverage, most of which are off-limits to conventional funds. With $1trn at their disposal, hedge funds are the vigilantes of the markets, pouncing at the first sign of weakness and getting tough with governments and companies that fail to deliver on their promises.

How long have they been around?

The first funds emerged in the US in the 1920s, but very little was known about them until the 1980s and 1990s, which saw the spectacular rise of a small group of Wall Street hedge-fund managers. The most well known of them was George Soros, the migr currency speculator famous for driving the pound out of the Exchange Rate Mechanism in 1992. In Europe, hedge funds were far slower to catch on. Crispin Odey set up one of the first in London in 1989. Indeed, five years ago there were still said to be only 35 hedge funds in London. But by the end of last year, there were more than 1,000 and new funds were being launched at a rate of one per day.

Why are they called hedge funds?

The term hedge fund' is a colloquialism derived from the expression "to hedge one's bets", meaning to limit the possibility of loss from a speculation by betting on the other side. The first hedge funds were cautious investments, employing complex strategies to protect people's wealth from the vagaries of the markets. But in the 1990s, the term became associated with the taking of giant bets, often using vast amounts of borrowed money. Sometimes these gambles can go spectacularly wrong. In 1998, Long Term Capital Management, a US hedge fund that boasted two Nobel laureates on its board, took a giant punt on the Russian bond market. When the bet went sour, LTCM collapsed with debt of $130bn, almost bringing down the entire global financial system.

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Are they risky?

There are many different types of hedge funds, some of which are very risky indeed. But most are marketed as safe investments, designed to deliver absolute returns - to make money regardless of whether the market is rising or falling. But each hedge fund will have its own particular strategy for success. The most straightforward form of hedge fund is the long-short fund, which is similar to a conventional fund except that the fund manager is allowed to sell shares short. Other funds employ more complex trading strategies, such as fixed income arbitrage funds, which try to exploit pricing anomalies across different markets or similar bonds, and so-called "market-timing funds", which dip in and out of retail funds, exploiting short-term pricing anomalies. Some funds, known as funds of funds, aim to spread risk by investing across a number of different hedge funds.

Who invests in hedge funds?

The vast majority are strictly off-limits to ordinary investors. Most require a minimum investment of $100,000 and many won't let you look at the prospectus unless you have $1m in your bank account. The first port of call when it comes to fund-raising is still Swiss private banks. But as the hedge-fund industry matures, institutional investors are becoming an increasingly important source of funds. Pension funds increasingly see hedge funds as a separate asset class alongside shares, bonds and property, and are setting aside part of their portfolios to invest in them. This week, the BT pension scheme, one of BT's largest corporate funds, announced that it is to invest in hedge funds for the first time.

Do hedge funds make money?

Yes. During the bear market, hedge funds were one of the best-performing asset classes. Between June 2000 and June 2003, the FTSE 100 lost 40% of its value, yet the CSFB/Tremont hedge fund index was up by 13%. Even over the last year, many funds have continued to perform extremely well. Vega Asset Management, a fixed-income, relative-value fund, has posted annualised returns of about 18% since its inception in 2001; Drake Asset Management's Absolute fund has similarly posted 18% returns since 2001; while the Pentagon fund, run by 35-year-old Harvard Business School graduate Lewis Chester, has produced returns of up to 37% over the last three years.

How much do the fund managers make?

The combination of steady returns and high gearing has translated into eye-watering payouts for the fund managers. Typically, funds don't charge management fees but take 20% of profits. According to recently filed accounts, Paul Marshall and Ian Wace of Marshall Wace were last year paid a total of £16.6m, while David Gorton, Rob Standing and Mark Corbett, founders of London Diversified Fund Management, were thought to have shared a £55m profit. But this is small change compared to what US hedge fund managers can earn. According to Institutional Investor, the top 25 US fund managers last year earned an average $110m each, and the top-paid fund manager, Bruce Kovner of Caxton Associates, earned a staggering $600m.