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ñichael Clarke, This is ñoney
12 July 2006
Deals

THE influence of hedge funds over the City has grown as quickly as investors' money has
flowed into the funds over the past 15 years.

UP OR DOWN: Hedge funds can make money regardless of which way the
market is moving

 

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These funds now reportedly manage over £750bn of clients' money and their highly-paid
managers can achieve remarkable returns.

Retail investors have so far been barred from investing in the funds, but that could change next
year. But what are these funds and what makes them so different to normal collective
investments? Read our report to find out.
  )*
  

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are collective investments that aim to make money whether the market is moving
up, down or sideways. Unlike  *))
)
, Oeics or investment trusts, which tend to only grow
when shares rise, hedge funds can make money when share prices are falling.

They do this using a range of complicated specialist techniques. The most commonly used is by
going long or short on a share. ñost private investors simply go long on a share, buying it in the
hope that the price will rise.

Where an investor goes short, they believe that the equity will fall in value. There are two main
ways that hedge funds can do this. The first is by 'shorting' the stock, where the investor
'borrows' a stock to sell it, with the hope that it will decrease in value so they can buy it back at a
lower price and keep the difference.

ÿor example, if an investor borrows 500 shares of X company at £10 each, they would then sell
those shares for £5,000. If the price then falls to £8 per share, the investor would buy the shares
back for £4,000, return them to the original owner and make a profit of £1,000.

Gnother way of taking advantage of falling share prices is by dealing in 'contracts for difference'.
This allows the investor to make money on share price movements without actually buying the
shares. G +' on a company's shares will specify the price of the shares when the contract was
started. The contract is an agreement to pay out cash on the difference between the starting share
price and when the contract is closed.

However, hedge funds are not only restricted to ,*)*

. They will invest in anything that will
make them a profit, including foreign currency, bonds or commodities. The return achieved by
the fund is likely to be dependent on the skill of the manager rather than underlying economic
conditions and that is why they are so well paid.

 * -
)*   

Gt the moment, hedge funds are only available to high wealth individuals who are prepared to
invest around £500,000 or to professional investors, such as pension funds or insurance
companies. Individual retail investors cannot buy directly into hedge funds as the City watchdog,
the +* .* /-*.
) *)0, is concerned about how the funds are operated and their risk.
Plus, it is unclear whether the hedge fund operators would welcome dealing with a large number
of small investors due to the costs involved.

However, the + will launch a consultation next year on whether it should increase the scope
of funds it authorises to include funds of hedge funds. Retail investors still wouldn't be able to
invest directly, but would be able to invest in an authorised collective investment scheme that
would put money into hedge funds.

Currently, if investors want exposure to hedge funds they can purchase shares in the companies
that operate funds, such as ñan èroup. It is also possible to buy into foreign funds over the
internet, although investors cannot expect the same financial protection that they would receive
in the UK.

*
*
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 . -   -*.

ÿ

 

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Ê
*
0 )0

Obviously, the level of risk depends on the strategy adopted by the manager, but they are
generally regarded as being higher risk than a normal collective investment. The reason for this
is many funds are 'leveraged', which means that they borrow money to add to their fund rather
than just using investors' capital.

Because many funds use *- )*-

, where they bet against the future value of the an asset,
rather than purchasing an asset directly, the funds are effectively borrowing the money. The
result is that gains and losses are magnified, with some making huge profits, but if things go
wrong the fund can go bust.

Glso, because the performance of the fund is so dependent on the skills of the manager, picking
the wrong one can prove costly.

)0/ )

The majority of hedge funds are domiciled offshore for tax reasons, but the UK-based managers
are fully regulated by the ÿSG. The ÿSG polices the market against illegal activity such as
insider trading and market manipulation. In ñarch, Europe's largest hedge  2  è è
and its former star trader Philippe Jabre were each fined £750,000 by the ÿSG for alleged insider
dealing offences.

However, the ÿSG does not regulate the funds themselves and, as a result, the organisations have
developed a reputation for secrecy. ÿor example, firms don't have to disclose their investment
strategies other than to clients, or reveal how they have performed. Glso, if a fund goes bust,
investors don't have any recourse for compensation. Gnd as mentioned before, hedge funds are
not currently among the collective investments authorised by the ÿSG.

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It is believed that there are around 8,000 hedge funds operating globally, managing over £700bn
of investors cash. The majority of funds are located in the US, but ondon is a growing, and
important, market for the hedge fund world. It is hard to measure their impact on the financial
markets, but it is estimated that these firms are responsible for around half of the daily turnover
of ondon Stock ñarket shares.

It is also thought that they wield considerable power over mergers and acquisitions due to their
tendancy to buy heavily into takeover targets. ÿor example, it was believed that hedge funds
played a key role in deciding the fate of the ondon Stock Exchange when several suitors were
bidding for the company earlier this year.

The term first originated in the 1940s after alternative investor Glfred Winslow Jones created a
fund that sold short some stocks, while normally investing in others.

Read more:
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