How's this for a sales pitch: we're going to take your money and invest it in an almost indescribably complex way. Some of our strategies may be similar to those that caused the infamous 1998 collapse of Long Term Capital Management, an investment house saved by a $3.6 billion injection from a collection of the financial world's biggest companies and the intervention of the U.S. Federal Reserve Bank. Oh, and don't forget: we'll help ourselves to commissions of up to 20% of your gains, our products are barely regulated, they're not registered with the U.S. Securities and Exchange Commission (SEC) and we're not obliged to report publicly where your money is going or how it's doing.
Sound risky? It is. So why are mainstream investors lining up to buy into so-called hedge funds, the esoteric investments that used to be the province of the superrich? For one thing, retail investors are tired of traditional mutual funds that tread water or worse. For another, respected firms like Man, a U.K. hedge-fund giant, are now marketing their products to people who have as little as $18,000 to invest. Although estimates vary, earlier this month the Alternative Fund Services Review, an industry publication, claimed that assets under management in hedge funds had surpassed $1 trillion. Another analysis firm puts the figure at more than $860 billion up from $456 billion five years ago. To be sure, hedge funds still account for less than 1% of assets under management worldwide. But a Goldman Sachs–Russell Investment Group study released in 2003 forecast that the percentage of European institutions investing some part of their portfolio in hedge funds will rise from 21% in 2003 to 50% in 2005.
What's the attraction? Huge returns. In 2003, hedge funds globally returned an estimated 13%, with a projection to do the same this year. That's more than double the projected return for equities. "We're looking for solid returns," says Malcolm Gray, finance director of Railpen Investments, the investment arm of Britain's Railways Pension scheme, which last month said it would invest $1.1 billion in hedge funds. "We think the price of bonds is too high; we're worried about the price-earnings ratios of equities. [With hedge funds] we want to get some absolute income in."
Yet even though the interest of big institutional funds has enhanced hedge funds' respectability, experts encourage investors to tread warily. The market has grown so quickly that some commentators are comparing the hedge-fund boom to the dotcom bubble. While the best funds do make lots of money, they generally require a long-term commitment from investors. And the lack of consistent and transparent strategies among various hedge funds doesn't help. Says Ian Morley, CEO of Dawnay, Day Olympia, a joint-venture asset management concern: "Hedge funds are many things, and hedged isn't usually one of them."
Hedge funds originated in 1949, and were for many years the province of the hyperwealthy, who used them to protect assets during market slumps. Some of that high-net-worth legacy still remains in the U.S., investors wanting to invest directly in a single hedge fund must have $1 million worth of assets, and $200,000 in annual income. They were designed to hedge against market movements, and thus while they mostly hold the same assets as traditional vehicles a mix of bonds, stocks, cash and property they use much more aggressive investment strategies, like short selling, where an investor seeks to benefit from declining market prices; derivatives, where an investor uses instruments derived from the price of an underlying financial asset; and arbitrage, where an investor tries to exploit price differentials between markets. Flat stock markets have meant dwindling returns for institutional investors, who have been forced to seek other ways to plug the shortfalls in their portfolios. In addition to Railpen pledging $1.1 billion to hedge funds, earlier this year British Telecommunications' pension fund said it planned to invest $895 million. Says Railpen's Gray: "We're trying to diversify. We're here to secure our pension promise."