Hedge funds: ill-fated and greedy risks

Over the last few months there has been much discussion about hedge funds and whether they should be regulated.

As a financial adviser, I have, on four occasions, met hedge fund managers or directors who were trying to drum up business.

The truth is that theirs are very complicated investments and not for the faint-hearted. Only a very small percentage of the population could be correctly advised to invest in hedge funds and only then as a small part of a big portfolio.

Unlike other collective investments, which invest in a specific country or sector or are compared against a benchmark of some sort, hedge funds chase what is known as an absolute return. The open-ended investment selection powers of a hedge fund manager mean that comparison with any one index is meaningless. A hedge fund manager is expected to make money no matter what happens in the market.

The ability to invest virtually anywhere and in almost anything should enable a profitable market to be available at all times, be it by buying long, selling short or using an arbitrage play. While this may sound like the ultimate investment format, it makes it very difficult for a private investor to gauge just how much risk is being taken with his or her money.

The majority of hedge funds fall into two distinct styles. They are either event or momentum driven. Event-driven means that they trade in the markets following news or financial events, seeking to gain from fast action and decision-making. Momentum traders are always looking for a hot market with plenty of liquidity. This enables them to buy, ride the wave and then jump off quickly, preferably before the tide turns against them.

These momentum funds add a layer of additional volatility and therefore instability into markets. The sheer weight of money entering a market forces prices up which creates extra new investors. When these funds exit their play, profits in hand, the asset will fall in value quickly too.

Hedge funds use leverage - technical speak for "they borrow money" - which adds to the risks substantially. Only recently, Amaranth Advisors lost in the region of $6 billion (€4.9bn). The collapse of Long Term Capital Management, an American fund, reportedly came close to endangering the entire US financial system.

Like it or not, hedge funds are all about greed.

The best managers flock to run or start their own fund because of the huge pay packets available. It is typical for a fund to charge similar fees to most other styles of investment fund, but most have an additional 20%-25% override on profits made above a certain preset benchmark.

For a fund manager, this is equivalent to striking oil or finding a seam of gold in the garden. It is reported that the manager of the ill-fated Amaranth Advisers earned in the region of $75 million in 2005.

The easiest time to lure in investors is at the fund launch. Results are theoretical according to the planned trading model, managers’ reputations are polished and big name banks are lined up as custodians and auditors.

Investors jump aboard hoping for bumper profits, seemingly oblivious to the risks and costs involved. They too are driven by greed. With so many funds out there, now believed to be around 7,000 worldwide, many using similar strategies, profits are far less easy to come by than in the early days. For most private investors, the rewards do not justify the risks.

• Stuart Langridge is an independent financial adviser www.stockexchangesecrets.com

Over the last few months there has been much discussion about hedge funds and whether they should be regulated.