FORUM: hedge funds

Hedge funds seem to be the latest recipe for institutional investment success, generating even more work for excited law firms. However, some argue that the risk outweighs the return.

They might not currently be available in the retail sector, but a number of banks and traditional asset managers are launching their own products. So are hedge funds the next big thing to hit the European private client investment market, or just another product with limited worth and application?

Known also as alternative investment vehicles, hedge funds have been around for some time, originating in the US in the mid-1900s. Being able to take speculative positions, these funds aim to achieve absolute returns irrespective of market conditions. The first such fund took short and long positions: selling short on the assumption that stock can be bought back at a lower price and buying stock on the assumption that it would increase in value. Widespread use is made of gearing in constructing these funds.

Simon Gleeson, senior associate in the regulatory group at Allen & Overy, believes that investors are still cautious since the collapse of the Long Term Capital Management hedge fund (LTCM) on 2 September 1998. He says that hedge funds cannot be regulated directly, since the funds are based mainly offshore. Direct regulation could be possible through the banks that provide facilities to the funds. Triggered by the LTCM affair, there have been various reports, summarily recommending that the lending banks disclose their exposure under the funds and that risk penalties be allocated for types of lending.

One of the problems in the LTCM affair was that the US bank lenders thought that they were fully collateralised against the securities pledged by the fund. Given the extreme gearing, when the banks called in their collateral they threatened to flood the market. The US Federal Reserve encouraged the orderly realisation of collateral, which showed how a financial disaster occurred despite the banks acting properly.

Gleeson sees hedge funds as residual funds which do not follow index-tracking strategies – the tip of the iceberg for global investments. His clients constitute investment banks seeking advice, but he says many institutions, particularly pension funds, remain wary, although he still thinks that funds of hedge funds will be the next big thing. He says: "Hedge funds are unsuitable for individual investors because they can be volatile, but in a mix of funds such volatility swings cancel each other out."

Tim Shipton, head of the investment management group at Linklaters, says there is a "high appetite for hedge funds in Europe of the long-short flavour". He observes that LTCM had an impressive track record and that their "methodology on how to manage returns worked for a liquid market, but the markets they were playing in were not so liquid. LTCM were the only players, so when the market fell they couldn't get out."

Shipton says there is a lot of activity from asset management clients and investment banks. Fund managers are also looking at Ireland and Luxembourg to put the fund into, rather than more traditional offshore centres. He says that Luxembourg is popular with Continental investors as they are used to doing business there. Shipton's view is that the funds are the "preserve of institutional investors". He says: "The UK regulatory system will not change to allow hedge funds to be marketed in the UK, as the current rules are adequate for them to be sold to the right sort of investor."

James Roome, partner at Bingham Dana says that hedge funds are very much relative unit investments and that investors are drawn to them "by a desire to get a higher level of performance". He acknowledges that there is an ongoing debate regarding the role of hedge funds. He says of LTCM that "there's a huge amount of excitement about regulation if they can bring down the US economy".