Dangers of high-risk funds attract the Irish

Hedge funds are too risky for retail investors, the UK's financial regulator has ruled, in a move that puts it at odds with Irish regulations on this type of alternative investment.

The Financial Services Authority (FSA) has decided against authorising the sale of hedge funds on the UK retail market on the grounds that these unregulated pools of private capital are subject to unacceptable levels of volatility for the average investor.

The FSA has also said it does not yet intend to relax rules on the retail sale of fund of hedge funds, which spread risk by investing across a number of separate hedge funds.

In the Republic, however, the Central Bank authorised the sale of retail fund of hedge funds in December.

Similar moves have also been made in other European countries, as well as Japan, Australia and Hong Kong.

"We just felt it was timely and we believe we put in enough safeguards to protect the investor," says Mr Michael Deasy, head of the Central Bank's IFSC and funds supervision department.

Under current British rules, hedge funds cannot be marketed to retail investors, who must either approach fund managers directly or go through a financial adviser.

Some hedge fund managers in Britain have expressed disappointment at the FSA's ruling.

"I think retail investors are best served by having the fullest range of choices available to them, including fund of hedge funds," says Mr Martin Phipps, head of the hedge fund business at fund manager Gartmore, a specialist in the area. "Given the turmoil in the markets, the average investor would benefit from having hedge funds in their portfolio."

Although hedge fund returns have been slack in the past year, many hedge fund managers have still been able to preserve capital at a time of declining stock markets.

Hedge funds have been in fashion during the recent period of poor stock market conditions, as investors search for alternative investments not directly correlated to the ups and downs of the markets.

A hedge fund invests in assets such as equities, property, currencies and commodities. They often, although less frequently of late, follow a strategy of "selling short" and using leverage to take bigger bets on the market.

Selling short is a bet that the price of an asset is about to fall. Short sellers bet on a price fall by selling shares that they do not own but have borrowed from institutional investors in the hope of buying them back later at a lower price.

Leveraging means borrowing beyond the value of the fund so it can do bigger deals on the market. This is partly the reason why hedge funds are considered a dangerous place to keep your life savings.

For example, if a hedge fund is 2.5 times leveraged and the value of the assets it buys falls by 20 per cent value, investments within that hedge fund will have lost 50 per cent.

Hedge funds are for high-risk investors only, cautions Mr Ian Mitchell of financial advisers Towry Law. "It's not for people who are speculating to accumulate; it's for people who have accumulated and want to make money when markets go up and when they go down."

Even highly sophisticated investors should hold a maximum of 10-20 per cent of their portfolio in hedge funds, Mr Mitchell adds. "If you've never had one before, you shouldn't go above 5 per cent."

The existing market for hedge funds in the Republic is small. Friends First's Insight Currency Fund and Insight Equity Fund are both hedge funds, while Irish Life plans to introduce a hedge fund product before September.

As the success of hedge funds relies heavily on the expertise of the fund manager, investors may see all of their money disappear if their manager has a bad run. But under the fund of funds model, retail investors can invest in a spread of funds to smooth out the return of individual managers.

The Central Bank has strict diversification rules for retail fund of funds schemes that propose to invest more than 10 per cent in unregulated schemes such as hedge funds, according to Mr Deasy.

They state that schemes may not invest more than 5 per cent of their net assets in the units of any one scheme or more than 10 per cent in the units of schemes managed by the same company. These limits are raised to 10 and 20 per cent respectively if the management company of the underlying scheme is authorised to provide investment management services.

Despite being less of a gamble than single funds, funds of hedge funds are still aimed at people with investment experience. The minimum investment by each investor must be €12,500.

In addition, the high risk attached to hedge funds must be clearly stated in the prospectus for any retail fund of hedge funds. Details of the investment style, the amount of leverage on the fund, potential liquidity problems and valuation difficulties, and the impact of fees on returns must also be included.

Outside these proposed retail fund of hedge fund products, there may be little transparency on the cut the fund manager takes. "There seems to be no rules, it's like the Wild West," says Mr Mitchell.

Investors should buy hedge funds from advisers who know what they're talking about, he adds.

Multi-manager and fund of fund managers will soon start to market retail fund of hedge funds, according to Mr Declan O'Sullivan, a partner at solicitors William Fry who specialises in investment funds law.

"We're seeing pent-up demand for absolute returns," Mr O'Sullivan says. The same demand just isn't there in Britain.

Ireland is a popular domicile for hedge funds: 292 are domiciled here, or 57 per cent of the total number of European hedge funds, so there is a high level of local expertise available in the field, Mr O'Sullivan notes.

Meanwhile, funds that share the same characteristics of hedge funds have significantly higher minimum subscriptions.

Professional funds require a minimum investment of 125 million, while qualifying investor funds have a minimum subscription of 250 million.

Investors in these funds must also satisfy minimum net worth requirements. - (Additional reporting by Reuters)