To cautious council pension fund managers, the idea of investing in a hedge fund can have all the allure of putting investors' money on a greyhound race.
Hedge funds have gained a mildly disreputable image from press coverage of flash individuals, spectacular collapses and huge amounts of money appearing to be made out of nothing. Like those who inhabit greyhound stadiums, hedge fund managers also talk their own arcane language and profit from activities incomprehensible to most outsiders.
In an effort to demystify hedge funds, the National Association of Pension Funds has produced a guide to what they are.
The NAPF says the key attraction of hedge funds is that they offer good diversification because they have little or no correlation to the equity and bond markets. That means hedge funds move for reasons unrelated to traditional markets, so bad times in those markets will not necessarily affect them.
Hedge funds invest in conventional markets - equities, bonds, currencies and commodities - but in unconventional ways, using methods such as leverage, short selling, derivatives and multiple investment strategies. This is a complex world, even by money market standards, and the people who excel at it are highly skilled. Indeed, most hedge fund managers will back their judgment by investing personal capital in their fund, and the degree to which they do is one way of judging a fund's performance.
Pension funds that invest in hedge funds will, the NAPF argues, gain access to some of the best brains in the finance industry, with the manager's skill, rather than the condition of the market, being the key factor in determining returns. It says that hedge funds have historically provided good returns even when traditional markets are depressed because their managers have freedoms to exploit opportunities. Furthermore, despite their image, hedge fund managers will not take unreasonable risks when their own money is invested.
Hedge funds need due diligence just like any other kind of investment. This is a complicated business, the more so because the focus on individual managers means these funds are peculiarly susceptible to problems of staff departures, or even sickness. Worse, many fund strategies are extremely complex and managers can be loathe to reveal them for fear of knowledge leaking to competitors.
For these reasons, most pension funds will prefer to use a 'hedge fund of funds'. These allow investors to go to an expert who can assess the performance of many funds and their managers - in a way that council pension staff would normally lack both the time and expertise to do - and invest in a range of them to take advantage of different skills and strategies.
One point to remember about hedge funds is their charging structure. The NAPF points out that while hedge fund management fees are 1-2% of the total of assets invested, performance payments are around 20% of returns. Using a fund of funds might typically add one percentage points to management fees and 5-10 percentage points to fees.
What do hedge managers claim to offer councils? Nadja Pinnavaia, head of the hedge fund strategies group for Europe and Asia at Goldman Sachs Asset Management, says: 'Where hedge funds tend to differ from regular public mutual funds is that they do not face many of the constraints that traditional asset managers do. For example, most traditional managers have strict guidelines regarding what level of cash holdings they may hold and the way they can trade.
'In addition, hedge funds do not necessarily judge their performance based upon a traditional benchmark, but rather their specified return expectations.
'The underlying philosophy of hedge fund investing is that it is the skill of the manager, rather than the return of the market, that is the principal determinant of how they will perform.'
She gives an example of the way the hedge funds exploit mispricing, one of the strategies used by some funds.
Ms Pinnavaia says: 'Suppose one looks at the prices of British Airways and Cathay Pacific and finds that there is a valuation difference driven by company specifics, such as corporate management, rather than a broader view of the airline industry.
'That could lead to a decision to buy one airline and sell the other to exploit that price difference while mitigating away the industry risk.'
She says pension funds typically might invest 60% in equities and have the rest in bonds. 'If so, as much as 95% of the risk they face may come from equities,' she says. 'By adding hedge funds to their portfolio, they may be able to shift some of the risk away from equities. In so doing, they may be able to improve the risk-adjusted returns of the portfolio, often taking less risk as a whole.'
Councils are increasingly exploring this market. But Ms Pinnavaia acknowledges that, 'pension plans may not be comfortable with the impression surrounding hedge funds, as often reported in the press.
'We spend a significant amount of time educating local authority funds about what hedge funds really do and do not do.' Her firm always asks local authorities about their overall objectives and what they are trying to achieve by investing in hedge funds.
Jamie Murray, head of marketing at HSBC Republic Investments, says hedge funds 'make a good deal of sense for pension funds if they are trying to diversify portfolios and give growth predictability in meeting liabilities'.
There is little need to worry about the sometimes adverse comment that hedge funds attract, he says: 'They have a racy reputation, making them seem a risk, but there are 9,000 in the world at any one time, and each year we might look at 1,000 and would only invest in as few as 200.'
One attraction is that some hedge funds 'operate in markets where perhaps traditional investment managers would not go. They are experts in exploiting inefficiencies in the markets'.
These can range from exotica such as traded weather derivatives, used by farmers to protect crop prices, through to more conventional trades like exploiting valuations movements from takeovers and mergers.
'Fiduciary duty is getting tougher for council pension funds and arguably they need to broaden beyond equities and bonds,' Mr Murray says. 'It is very important to work through a fund of hedge funds manager who can get in-depth research. Some will employ 100 people, with one-third working on research. That is something no investor could do for themselves.'
This is the approach taken by two councils that have entered the hedge fund market. Martin Spriggs, head of investment at the Brent LBC pension fund, put 5% of the fund into a hedge fund of funds in March 2005 and says: 'I only wish we had done this in 1999 before the dotcom downturn.'
Brent looked at the record of hedge funds and chose Fauchier Partners, a fund where 'directors invest their own money, which gives us a fair degree of comfort'. He found they did well when equity markets turned down, targeting an absolute return of 5% above the bank rate.
'They have a record of getting returns through markets that are both difficult and good,' Mr Spriggs says. 'I was very impressed by their risk averse nature and by the depth of research they do.'
He says it would have been impossible for Brent to assess funds individually, which meant it had to use the fund of funds route. Another factor was the depth of experience on offer. 'Chief investment officers of major city institutions have moved to hedge funds. They are hugely experienced people who have done very well.'
Flintshire CC has invested 4% of its portfolio in hedge fund of funds Pioneer and Quellos, says assistant county treasurer Dave Bamber.
An optimisation exercise showed that the fund of funds both improved return and reduced risk, he says, proving a strong diversifier that can use multiple strategies and reduces the risk of depending on any one manager. Flintshire has gained its expected advantages and suffered no disadvantages from its involvement, Mr Bamber says.
In both cases, training was offered to councillors so they felt comfortable with hedge funds.
Hedge funds are slowly becoming an accepted part of pension fund operations, which should mean
they become steadily less mysterious to officers and councillors.