Hedge funds

New proposals would give private investors wider access

The FSA has laid out plans to allow some funds of hedge funds, which aim to achieve returns regardless of underlying market conditions, into its existing regulatory regime.

For private investors there are already two practical ways to buy into hedge funds. These are funds of hedge funds, listed on the London Stock Exchange (LSE), and long/short UCITS III funds, which open up the possibility that managers may benefit from falling markets.

Funds of hedge funds are investment companies that invest in a range of individual hedge funds. This is a sensible approach as holding a range of funds spreads risk.

The UCITS III route is usually less expensive, but there are few equity long/short funds to choose from. There is a greater choice of 'target return' funds, which primarily invest in fixed interest. The FSA announcement means that conventional funds of hedge funds may also become accessible to retail investors, not just those listed on the LSE.

The "funds of funds" approach should impose greater diversification to reduce exposure to setbacks or failure at any one company or sector than any single hedge fund might provide. This would introduce other important safeguards for investors such as including the requirement to have an independent depositary as well as strict rules on independent valuation of underlying assets and timely redemption of investments.

The new rules would enable hedge funds to be directly marketed to individual investors for the first time. The proposals were subject to a consultation period, which closed on June 27. The FSA will then finalise draft rules.

But even if the proposals are adopted, these funds of hedge funds are definitely not for the fainthearted. The name hedge funds is generic yet covers one of the most varied financial products available in the UK.

Hedge funds use different investment strategies, from exploiting price differentials in different markets, to short-selling, where fund managers sell shares they do not own in the hope the price will drop before they need to deliver the stock.

As well as going short, hedge funds can also go long, that is to say, invest in companies they consider undervalued in the hope the share price will pick up over the long term.

The emergence of funds of hedge funds has made them more accessible, with entry costs from around £5,000 to £10,000. One of the most appealing characteristics of hedge funds is the fact that many have low levels of correlation with other asset classes, and can also benefit from low levels of volatility.

The benefits of hedge funds for private investors are twofold. First, investing across a wider number of asset classes helps to diversify risk. Second, it can help to smooth overall returns as shown by the multi-asset style of investing adopted by US endowment funds over the last 20 to 30 years.

Positives:

• Ability to short-sell
• Leveraging, or being able to borrow, could boost returns
• Aims to deliver positive returns irrespective of market movements
• Low correlation with other asset classes

Negatives:

• Short-selling can be a high risk activity
• Borrowing to invest can be speculative
• Charges are typically higher than unit trusts and OEICs
• Minimum entry investment costs can be from around £5,000 to £10,000

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