Hedge funds have acquired a fearsome reputation in recent years, largely because people still remember how George Soros’ Quantum Fund helped force the pound out of the European exchange-rate mechanism in 1992.

The irony is that, despite their high-risk image, hedge funds were originally designed to protect against risk, rather than maximise it.

So here is a quick explanation of what hedge funds are, how they operate and how you can invest in them.

What is a hedge fund?

An investment that aims to make money year in year out, no matter what the financial climate (known as an absolute return strategy). How to define hedge funds is tricky, because it is an umbrella term for a huge range of different investment strategies and risk levels. One thing they have in common is that wealth preservation, i.e. not losing money, comes very high up the list of priorities.

Why do they seem so scary?

Their sheer size (many funds are worth billions of pounds) is enough on its own to command attention but it is the frequency with which they trade that gives them a profile even bigger than their size alone would merit. Market experts reckon that hedge funds account for as much as 50 per cent of all trades on the London Stock Exchange.

When hedge funds combine to bet on a particular outcome, as they did with the pound in 1992, even Governments can find themselves powerless to resist the momentum they generate.

How do hedge funds work?

They use a number of strategies to make money for investors.

Perhaps the most notable one is the long-short equity strategy. This allows the fund manager both to ‘go long’ - the traditional approach of buying an asset in the hope it will rise in value - and to ‘go short’ - selling a borrowed asset in the hope of buying it back more cheaply later.

Another approach is arbitrage, where the fund manager takes advantage of anomalies in the pricing of assets. For example when a company's shares are quoted in two different countries arbitrageurs may see a slight advantage in buying the shares in one country rather than the other. To see arbitrage in action, use an online calculator.

A third method of money-making is to take a significant stake in a company, in the hope that a profitable takeover or management shakeout will follow.

Are hedge funds suitable for the man in the street?

There are a number of hurdles which a typical private investor would need to clear before investing in a hedge fund. The first is that the initial investment required is usually very high. It is rarely less than £50,000 and can be £1 million or more, which rules out all but the wealthiest investors.

Hedge funds are based offshore and are not regulated by the Financial Services Authority so the usual warning about seeking advice before buying applies with extra force in this case.

Although not all hedge funds are high risk some of the strategies used by some of the funds undoubtedly are. For example the use of specialist instruments known as derivatives offer highly geared bets on the future price of things like shares or commodities and investors need to be sure they appreciate the level of risk that their hedge fund is running. Hedge funds also typically use leverage. This involves borrowing additional money to increase the size of the bets they are taking.

How much does all this expertise cost?

Quite a lot. Hedge funds typically charge 2 per cent a year in annual fees, plus a performance fee of 20 per cent or more of any rise in the fund’s value. Performance fees are rewards to managers for achieving a certain level of return. The idea is that by offering these incentives the fund ensures that both the managers and the investors have a strong interest in the fund doing well.

Does the performance of these funds justify the high fees?

It’s impossible to give a blanket answer to that question, but it’s certainly fair to say that the high charges act as a drag on performance.

Last year the average return on European hedge funds was just under 10 per cent, according to HedgeFund Intelligence, an industry information group. This compares with the return of 18.1 per cent posted by ordinary European equity funds.

However hedge funds did much better in the bear market of 2001 and 2002. While the stock market was down 45 per cent hedge funds were up by 1 to 2 per cent. Because hedge funds aim for absolute returns they tend to do better than the stock market in bad times but less well in good times.

How do you go about buying a hedge fund?

Your financial adviser should be able to point you in the right direction, though, as mentioned above, you will need a substantial initial sum and you could be buying into a potentially very risky investment.

Charles Cade, of Winterflood Securities, the stockbroker, says he would not recommend direct investment in hedge funds. A better route would be a fund of hedge funds, which invests in a number of different funds. There are more than 20 listed on the London Stock Exchange.

However they do have drawbacks. They usually charge another layer of performance fees on top of those levied by the underlying hedge funds and and like hedge funds, are not currently regulated by the FSA, though the watchdog is thinking about bringing some funds of hedge funds under its regulatory umbrella.

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