First, a hedge fund manager has the flexibility to invest in a wide range of asset classes and can employ investment techniques that are not available to traditional investment funds. These include borrowing money - or leveraging - to invest in companies or markets the manager finds attractive, and taking positions in which the manager will gain if share prices fall in value, which is known as short selling.
Second, whereas a unit trust generally measures its performance relative to an equity benchmark, such as the FTSE 100, a hedge fund seeks to deliver absolute returns under all market conditions, regardless of how the equity and bond markets perform. Hedge fund managers can therefore be effective in helping to preserve capital in periods of market downturn.
Hedge funds typically offer lower volatility and higher risk-adjusted returns than traditional asset classes such as equities and bonds. And because they tend to have low correlation with these assets - in other words, they do not react the same way to changes in market conditions - including hedge funds in a diversified portfolio of assets can improve the overall risk/return profile.
But despite the potential benefits of hedge funds, most charities find it hard to access them directly. This is partly because of the large number of funds - there are more than 6,000 - and the difficulties of understanding the vast range of strategies they follow.
Direct access is also limited by the minimum investment levels demanded by individual hedge funds. The minimum is usually several million pounds. And because you would not, of course, want to put all your eggs in one basket, achieving a diversified portfolio through direct investment is confined to those charities that have hundreds of millions of pounds to invest.
Fortunately for the charity with limited assets to allocate to hedge funds, the industry has developed a fund of hedge funds pooling system similar to that of the unit trust industry.
Fund of hedge funds vehicles have the resources to monitor a large proportion of the hedge fund universe, enabling trustees to outsource this labour-intensive task. Hedge fund managers are among the largest investors in hedge funds and consequently have access to funds that are often closed to smaller investors. So if you believe your charity's portfolio could benefit from some exposure to hedge funds but assume they are out of your reach, it might be time to think again.
- Clive Paine is head of UK distribution at HSBC Alternative Investments Limited.