It's worth taking a bet on alternative investments

For those one or two of us who have been impressed by the quiet way in which corporate Germany has been restructuring itself with some very modest help from the government, news that hedge funds - the new "locusts" - are to be "investigated" comes as a grave disappointment.

German equities have been doing relatively well over the past couple of years, notwithstanding the truly awful news from the wider economy, because markets sense a turnaround story: the ossified structures of Germany's product and, in particular, its labour markets might just be about to change for the better. Indeed, if Germany and the words structural change can be mentioned in the same sentence, I think that many different types of German assets will perform well.

In particular, Germany has probably the cheapest property market in the industrialised world. Any improvement in the overall outlook that ensues from tough reforms now will tempt investors into the last great untapped real estate market.

So, it is disappointing to observe government-led efforts to figure out a way to rein in the activities of hedge funds and other investors who are taking a much more aggressive stance in the demands they make of the companies that they buy. It cannot be a coincidence that the German Dax index has, most recently, started to sink down the global league tables.

The catalyst for government angst has been the forced resignation of Werner Siefert, the chief executive of Deutsche Börse, and its chairman, Rolf Breuer, after a failed takeover bid for the London Stock Exchange (LSE). Two hedge funds in particular, one based in London and the other in New York, have been blamed in Germany for the debacle. All they did was demand a shareholder vote on the bid for the LSE, something that doesn't seem too outrageous. But it ran counter to what the chairman and chief executive wanted, presumably because they thought they would lose.

Thankfully, I wouldn't read too much into all of this, mostly because Gerhard Schröder, in particular, is playing to the gallery rather than launching an all out war on hedge funds.

But the increasingly high-profile activities of hedge funds, private equity groups and other "alternative" investment managers are raising all sorts of questions, not least "should individual investors have money with these sorts of managers?"

The short answer to this question is yes, but, as with a poker game, don't play with money you can't afford to lose.

Alternative investment managers exist mostly because of the money left on the table by traditional investment managers. They exist to exploit pricing anomalies created by the activities of others. They like to portray themselves as highly sophisticated, very mathematical, super-savvy investment professionals. Like most promotional literature, such sentiments should be taken with a pinch of salt.

Too many hedge funds end up doing the same thing and fall victim to the curse of orthodox fund management - trend following.

The distinction between private equity and hedge funds is beginning to blur: hedge funds are beginning to take on activities more usually associated with private equity houses. The latter traditionally buy whole companies, clean up (usually clean out) the management and sell the business on as a going concern (this has, in fact, been of considerable benefit to many German companies). Hedge funds traditionally buy shares in companies in the hope they are going up and rarely get involved in management issues.

However, this has been changing. Many of us think that, with the proliferation of hedge funds, the easy money has been made and now there is an increasingly desperate search for new ways to make returns. Hence, hedge funds are getting involved with issues normally the preserve of private equity.

Other news from the alternative investment world has focused on the unravelling of complex derivative-based strategies by hedge funds involved in corporate credit markets. Apparently, a lot of funds were all at the same game (trend following again), one that has gone wrong.

Putting your own money into hedge funds and/or private equity has been getting easier but it has yet to become a mainstream investment vehicle. Even with the easy money having been made and high returns likely to become increasingly elusive, a portion of many investors' portfolios should be allocated to this area (just how big depends on a host of factors such as time horizon, risk tolerance etc).

I put a tiny amount of money into a leveraged private equity fund more than five years ago and the fund's literature suggested that, if future performance was to be like the past, I could expect to multiply my money by around a factor of six after roughly 10 years (that's approximately 21 per cent per annum compound growth). No, I didn't believe it, but I thought it worth a punt, just on the off chance.

The moral of this story is that the fund didn't expect to be paying money back to investors this side of a decade and, while hinting at super returns, stressed that we could lose all our money. It is this kind of thing that any investor in private equity can expect (although expected pay-off periods vary a lot, they are usually long and imprecise).

Alternative investment managers are approaching the mainstream. They are, generally, a force for good. They have produced better returns and are contributing to the increasing professionalism of the whole industry.

More individual investors should take a look at them, notwithstanding current negative publicity.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.