Investors enter a hedge fund maze

Once the playthings of the wealthy, these complex products have now hit the high street. Should you be tempted? asks Sam Dunn

Their popularity is soaring, prices are falling and they're coming to a high street near you. Hedge funds, exotic financial tools more usually the preserve of the fabulously rich, have emerged from the shadows to find their way into the mainstream within the space of a year.

Their popularity is soaring, prices are falling and they're coming to a high street near you. Hedge funds, exotic financial tools more usually the preserve of the fabulously rich, have emerged from the shadows to find their way into the mainstream within the space of a year.

Last week, they took the final step of their journey from international financial wizardry to the much less mysterious British high street. The Woolwich has pushed hedge funds into the spotlight with a savings plan that lets you invest indirectly in an index of some 40 funds for as little as £3,000.

It is the latest in a line of summer manoeuvres by firms jockeying to cash in on investors' hunger for returns potentially as high as 20 per cent a year.

A hedge fund from Close Man, launched in June and asking for a minimum £10,000 stake, has been deemed so successful that the provider is to unveil a second fund this week.

"It's gone mad with hedge funds in the last few months," says Ryan Hughes of independent financial adviser (IFA) Chartwell Investment.

"People have been fed up with getting negative returns on their savings and are willing to try other things."

And they don't come more racy than hedge funds. Put simply, these aim to generate absolute returns - where you get back more than you put in - and to "hedge" investment risk by using complex products such as derivatives and options.

Managers adopt strategies that bet on different financial or geopolitical outcomes - and try to prosper in bad times as well as good. This is the key to the funds' appeal: markets may plunge but a hedge fund will endeavour to make money somewhere.

A popular hedge fund move is to "go short". A small fee is paid to borrow other people's shares and these are then sold in the hope of buying them back at a lower price later - making a neat profit in the process.

Some managers jump on price movements between commodities such as coffee or oil, while others might buy shares in both Tesco and J Sainsbury, say, to gain from industry boosts but cover themselves against poor performance by individual companies.

The funds trade offshore in places such as the Channel Islands to take advantage of light-touch regulation. In Britain, City regulator the Financial Services Authority has so far taken a prohibitive view, stipulating that hedge funds can be neither based here nor marketed direct to the general public.

Not surprisingly, perhaps, their growth in popularity has sparked unease. Although IFAs increasingly suggest that they could be given a small space in individual portfolios - "no more than 5 or 10 per cent," says Justin Modray of IFA Bestinvest - there is concern at the number of products available. The danger is that a glut of funds all using the same techniques and chasing the same markets will lead to smaller gains, Mr Modray warns. "The more funds there are spotting opportunities in the market, the fewer opportunities there will be."

Cash has already poured into the best-performing funds, which are now closed to new money, he adds. "If you get into the market now, there's a danger that you'll be getting second-rate managers."

He and other IFAs are also concerned at the emergence of hedge funds that guarantee your money back if performance wanes. Products from both the Woolwich and Close Man include a promise to protect your money.

The Woolwich plan, which is also being sold in Barclays branches, will return all of your original investment if the FTSE Hedge index takes a nosedive - as long as you keep your cash locked up for the full five-year term. However, there is a catch: you'll only get two-thirds of any index growth.

Paying such a high price for peace of mind may not be worthwhile, says Ian Lowes of IFA Lowes Financial Management. "You have to ask [yourself] if now really is the time for protection with such funds; they are preying on fear of loss [among investors]." And people taking a punt on hedge funds now could lose out on a stock market rally over the next few years, he adds.

Mr Modray says a well-run hedge fund shouldn't need a safety net. "Having a protection product is a bit superfluous: the whole idea of a hedge fund is that it mitigates market risk."

Sceptics might suggest that the funds have come to the fore because, in Mr Modray's words, "nothing else is really selling - companies are jumping on the bandwagon". However, if you are still prepared to take a punt, most IFAs recommend buying shares in a fund of hedge funds to spread the risk.

These products are usually investment trusts and can be bought from a broker or IFA. Mr Modray likes Thames River Hedge+, and Alternative Investment Strategies.

If you do have a spare £10,000 or more, are prepared to accept the risk and want to buy directly into a hedge fund, watch out for the high costs involved. As well as the expense of buying into the fund and the annual management charges, you face the prospect of hedge fund managers creaming off up to 20 per cent of the profits in fees.

It can also be difficult to monitor the performance of hedge funds, given that most are reluctant to share information openly.

If you are at all unsure, Chartwell's Mr Hughes has a reminder: "Don't invest in anything you don't understand."