Hedge funds, however, have become more accessible with the growth in the number of fund of hedge funds. As the name suggests, these are multi-managers who hold a number of hedge funds and different strategies in a portfolio. They can thus spread risk across both managers and strategies and offer lower initial investment requirements. You need to verify they can access high quality underlying hedge funds, however.

Increasingly, hedge funds are being established “onshore” with the same regulatory regimes as unit trusts. The Financial Services Authority in the UK has signalled its willingness to allow fund of hedge funds to join the onshore regulatory regime and be marketed to retail investors for the first time.

As we said earlier, there are many different hedge fund strategies. Perhaps the most common strategy is equity long/short. A manager will take long positions in equities where he expects the share price to rise and go short where he expects the price to fall.

In merger arbitrage, managers tend to take long positions in companies subject to a takeover bid and short the shares of the bidding company. The major risk is if the deal fails to be completed.

Distressed securities managers buy shares in bankrupt companies where they are at a discount to the company’s intrinsic value. They may become involved in helping to restructure the company.

Global macro is one of the best known strategies because of the activities of managers like George Soros. They take directional positions in any asset class in any region on the basis of top-down views of the global economy.

Market neutral funds try to neutralise market risk by simultaneously taking long and short positions. Some managers match long and short positions by sector, market cap or other criteria. This can enhance returns by selecting out-performing stocks while minimising market risk. Ideally, a manager will take a long position in a stock that rises in value and short a stock that falls in value where the overall market direction is difficult to predict. While stock market volatility can be reduced, this can lead to little out-performance.

As a result of the different strategies and investment flexibility, it is impossible to generalise about the risk return characteristics of hedge funds. The fund of hedge funds should enable you to reduce risk compared to investing in a single hedge fund. This is because you are spreading risk across hedge fund managers and strategies. Indeed, some fund of funds and single hedge funds are designed to reduce risk in a portfolio through low correlation to other asset classes and by having low risk mandates.

This is not to deny that hedge funds can pose relatively high risks, such as through the use of gearing. Due diligence needs to be conducted because of the potential for lower transparency and regulation than in the mainstream investment industry. It is suggested that around 25% of hedge funds are wound up within two years of being launched. Many hedge funds, however, close because the manager has failed to raise sufficient capital to make it cost-effective to continue rather than because of poor performance. In these cases, the initial capital is returned to investors along with any profits.

This last point raises questions about how much importance you should place on hedge fund indices. This is because of survivor bias, in which wound up funds are not included within indices. This can provide an upward bias to index performance.

A risk of investing in hedge funds is liquidity, or in some cases the lack of it. Many hedge funds and some fund of hedge funds only allow you to redeem capital every month or even three months.

Despite these concerns, hedge funds are likely to play an important role in your investment portfolios. This is because of their attractions as a risk diversifier as they can have low correlations to other asset classes. Generally, they have greater investment flexibility than mainstream funds and can exploit inefficiencies wherever they find them.