Hedge funds have garnered a fearsome reputation. George Soros’s Quantum Fund is still remembered for its role in forcing the pound out of the European exchange-rate mechanism in 1992. Last year Amaranth Advisors had to be wound up after losing more than $6 billion (£3.2 billion) playing the energy market.

Despite this notoriety, the reality is that most hedge funds do not set out to be risky. Edward Morse, sales director at Thames River Capital, the fund manager, says: “The problem with hedge funds is that it is a catch-all name to cover a vast range of investment strategies and a huge range of risk-and-return profiles.

“Some are much more aggressive than others. The vast majority of hedge funds are run by very conservative people whose main aim is capital preservation. And most of them have a significant proportion of their own net worth invested in their own funds, so there is a strong incentive not to lose money.”

Few hedge fund investors should have lost money last year. Figures from HedgeFund Intelligence, an industry information group, showed that the average return on European funds was 9.6 per cent. Even so, most still probably lagged behind traditional “long-only” investment funds.

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Building a portfolio is not rocket science, whatever City players drowning in cash might claim

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Background

• How to understand the financial pages

• How to find a reliable financial advisor

• Ten things to know about financial advisors

• Ten things to know about spread betting

Neil Wilson, of HedgeFund Intelligence, maintains that hedge funds perform best when helping investors to prevent losses. He says: “In 2001 and 2002, when the equity market was down 45 per cent, our equity indices were up, but only 1 per cent to 2 per cent. So outperformance tends to come in the downdrafts, when they protect, and they tend to lag in the upswing, because of the cost of taking short positions.”

Despite their protective qualities, these short positions carry higher risks. With a long-only fund, the most you can lose is your investment. A hedge fund may use much riskier strategies, often involving futures and options, where losses can end up being several times your original stake. What is worse, you will not generally be able to buy into a fund for less than £50,000.

Jacob Schmidt, whose Schmidt Research Partners researches and rates hedge funds, says this means that even people with relatively large sums of money to invest will find it hard to build a sensible hedgefund portfolio. Even if you have the money, you will find that there are virtually as many strategies as the 12,000 or so hedge funds that exist across the globe. But from this welter of approaches, the following three are relatively easy to understand.

Long-short equity

This was the classic hedge fund strategy pioneered by the American investors Benjamin Graham and Alfred Jones, before and after the Second World War. Basically, it involves combining the conventional role of fund managers, who buy and hold shares in the hope that they will rise in value, with the ability to go short.

Chris Mansi, a hedge fund expert at Watson Wyatt, the investment consulting firm, says: “With a normal fund manager, you give him £100 and he buys £100 of stock. He only buys things that he thinks will go up. If he thinks that they will go down, he simply won’t hold them.

“If a hedgefund manager thinks that a stock is going to go down, he will borrow the stock from someone else, sell it, wait for it to fall in value and then buy it back at the lower price to profit from the drop. He will then give the stock back to the person he borrowed it from.”

This gives hedge funds much greater flexibility to benefit from falling share prices, as well as rising ones.

Global macro

The global-macro manager bets on general economic variables, such as economic growth or the cost of money, rather than shares.

Mr Schmidt says: “Rather than taking a bottom-up approach, looking at individual companies, you are looking at the global picture and the major drivers in the market, such as interest rates, commodities, the economy or inflation.”

Arbitrage

An arbitrageur traditionally takes advantage of anomalies in the pricing of assets. The problem is that the market has grown wise to these tactics and the old pricing anomalies are thinner on the ground.

Instead, many “arbs” have changed their spots and become “activists” who take largish stakes in companies to shake things up. Mr Mansi says: “They are looking for companies that will be subject to change, be it a restructuring or a takeover, and then they agitate for that change.”

However, with hedge funds charging up to 2 per cent a year in annual management charges, plus 20 per cent or more of the profits, some investors may question whether any hedge fund is worth its fees. This has provided an opening for Goldman Sachs and Merrill Lynch, who have launched funds that use computers to replicate the performance of hedge funds at a fraction of the cost.

Hedge funds are usually based offshore and are not regulated by the FSA, so the usual warning about seeking expert advice applies to this sector more than most.

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