A gamble for the common man

A new FTSE hedge fund offers a safety net for nervous investors. But do the returns justify the means, asks Faith Glasgow

Barclays Bank's Woolwich arm broke new ground this week when it launched an investment product designed to offer ordinary investors with as little as £3,000 a route into the traditionally high net worth world of hedge funds. The Protected FTSE Hedge Plan will produce returns linked to those of the FTSE Hedge Index, launched in July to mirror the performance of a cross section of 40 leading hedge funds.

The Woolwich plan offers the guarantee of full capital protection, even if the index plummets through the floor. But the price of that safety is investors receive only two-thirds of any growth in the index over the five-year term of the investment, and they have to stay in for the full term to qualify for the safety net.

Colin Dickie, product manager at Woolwich Plan Managers said: "Hedge funds are considered risky by many investors, but they actually provide a useful balance to portfolios made up of more frequently held investments such as equities and bonds."

But why should small investors be interested in tapping into a market that has been out of their reach for so long? Aren't there easier, less scary ways to access an entire market? Here is a guide through the pitfalls.

What are hedge funds?

Hedge fund managers are based offshore, where there is a lot more investment freedom, fewer regulations and greater opportunity to take risk. In a nutshell, unlike conventional funds that aim to beat a benchmark (though that may still involve losing money in a bear market), hedge funds aim to produce absolute returns, making money regardless of whether the market rises or falls. That means they don't simply buy stocks and hope the price will go up. They can do that, but they also follow other strategies, some very sophisticated, depending on the state of the market and what they expect it to do. For example, they can go short - selling now and buying back later - in anticipation of prices falling so they buy back cheaper and make a profit that way.

Sounds nerve-wracking. I wouldn't put my hard-earned savings there

You wouldn't normally get the chance. Entry levels for hedge funds typically start around £50,000 to £100,000 into each fund and may go up to £1m or more - making it impossible for all but extremely well-heeled investors to hedge their bets by investing in several hedge funds.

I do like the sound of absolute returns. How do they work?

One of the big attractions of hedge funds is that their performance does not correlate closely with that of either equities or bonds. So your stocks and equity funds might crash, but your hedge fund might make money on the falling market.

What's the problem with investing in a single hedge fund?

They're inherently highly risky, and many fail to deliver the goods. Going short can be a disaster. Moreover, different funds utilise different hedging strategies and overall performance can be improved by mixing and matching. Until now, funds of hedge funds - typically holding 30 or 40 single funds - provided a means for smaller investors to tap into the market. But they tend to take a particular view of the market and it's not a straightforward proposition for the average investor.

How does this new index help?

The FTSE Hedge index is based on 40 funds that meet certain investment criteria. They have to be open to new investors (many funds are closed), at least two years old, have at least $50m (£28m) under management, and be "representative of their strategy", which means being typical of that type of hedge fund.

Money invested in the Woolwich plan will be ploughed into the funds making up the index - so it will be spread across well-established hedge funds, and track their fortunes.

It's a kind of tracker fund, then?

Effectively, yes. Conventional tracker funds that mirror the ups and downs of stock market indices are liked by investors because they provide automatic diversity with exposure to a whole market. They can be run by computer and are cheap as they do not depend on the judgement of fallible human managers. In the same way, this hedge fund tracker provides exposure to a diverse range of funds and - importantly - does away with the need for individuals to take a view on a pretty complex and user-unfriendly market.

But why, if hedge funds aim for positive returns in all markets, will investors have to sacrifice a third of all their gains for a capital guarantee that they are relatively unlikely to need?

Good question. Woolwich says that its products are "targeted towards the cautious end of the market", so it's providing a comfort blanket for nervous investors. At this early stage in the FTSE Hedge index's existence there are no alternative tracker investments available to ordinary consumers, so if you want the portfolio protection that this basket of hedge funds can provide, you have to live with the safety - and penalty.

Where do Exchange Traded Funds fit into the tracker universe?

ETFs are relatively new in this country and so far haven't really taken off, but they do offer advantages over old-fashioned tracker unit trusts - you can sell them short in a falling market if you have that arrangement with your broker. Like other tracker funds, ETFs invest in a basket of shares designed to track the performance of a particular index. They provide equity diversification and access to entire geographical regions.

But they are cheaper and more flexible than unit trusts as they are structured differently. Instead of buying units in a fund (which are traded once a day), ETF investors hold a share that can be traded on the stock exchange at any time. Dividends are paid out regularly instead of being reinvested.