Nevertheless, barring any scandals and provided that hedge fund returns can offer charities protection against weak traditional markets, it seems that this new market is here to stay.
THREE HEDGE FUNDS USED BY CHARITIES
ABSOLUTE RETURN TRUST FOR CHARITIES, CAZENOVE FUND MANAGEMENT
This is the only common investment fund that invests in hedge funds and was launched in December 2002. The ARTC is advised by Fauchier Partners, a specialist in constructing hedge fund portfolios.
It is a fund of funds and has holdings in 29 hedge funds with nearly £30m of funds under management from charities. It aims to provide an annual return of 8 - 10 per cent a year and had a return of 6.1 per cent from last December to the end of June. As a common investment fund it is authorised by the Charity Commission. Minimum investment is £50,000 and the annual management fee is 1.5 per cent.
The fund aims to enable diversification across different strategies to give less volatile returns than a conventional equity and bond portfolio.
Cazenove says it prefers not to associate individuals with particular products but directors John Gordon and Edward Harley take a particular interest.
BARING HEDGE SELECT FUND, BARING ASSET MANAGEMENT
This fund of funds was set up in 1999 and aims to produce steady returns of 5 per cent a year over cash, with low volatility. The minimum investment is £70,000 and annual management fees are 1.75 per cent. There is no performance-related fee. The fund's size was $97m (£62m) at the end of June.
Tomas Maier looks after the fund. He joined Baring in 1982 to specialise in Japanese, Pacific and Australian investments. Maier joined the alternative investment committee, which is responsible for hedge funds, in 2000, and is now head of alternative investment.
SAIF BLUE SEA, SCHRODERS
The SAIF Blue Sea fund invests in about 25 hedge funds and targets an absolute return of 6 - 9 per cent above dollar cash returns. It is one of three funds of funds managed by Schroders and has the lowest risk.
The others are Blue Star and the higher risk Blue Mountain. Blue Sea was launched in November 2000 and in the first half of this year its return was 6.27 per cent. The fund has about 20 charity clients. There is no minimum investment for Schroders clients, but for others it is £35,000.
Portfolio manager John Parkin joined Schroders in 1995. He played an active role in developing a framework for asset allocation decision making and risk analysis and was a member of the Private Client Group Asset Allocation Committee. He joined Schroders' Hedge Fund team in 2000.
Charities have traditionally shied away from hedge funds, regarding them as high-risk and too complex. But they are growing in popularity because of the protection they can offer when markets are tough.
A couple of years ago, hedge funds were rarely used by charities, despite their growing reputation for achieving positive investment returns when markets were falling. Hedge funds were regarded as a high-risk and hard-to-understand product that all but the biggest charities would do well to avoid.
Today the debate has moved on and an increasing number of charities - although still a small minority of all charity investors - are looking to put a proportion of their investment in hedge funds.
This is down to a number of factors, which include new guidance from the Charity Commission earlier this year, the launch of the first common investment fund specialising in hedge funds last year and a desire among many charity trustees to diversify their investment portfolios.
But what exactly are hedge funds and how do they work?
The hedge fund was developed in the US and is one of the fastest-growing investment products. There are now more than 6,000 of them worldwide and they are usually registered off-shore, which means they bypass UK regulations.
Hedge funds are a complex kind of investment that use derivatives (financial instruments that are derived from shares, bonds and other securities) and borrow to magnify their positions in markets. Many bet on market movements and attempt to provide a real return even if markets are heading downwards.
One of the most famous hedge fund transactions was when international financier George Soros 'broke' the Bank of England by betting against sterling in the 1992 financial crisis under the then Prime Minister, John Major.
Among the most controversial practices of some hedge funds is "short selling", in which funds borrow shares from investment institutions and then sell them, with a view to buying them back for less when the price has fallen.
Generally, hedge funds aim to make a real return even when markets are falling, but when markets are rising they will generally only return a proportion of the increase. In other words, if the equity market is rising strongly, hedge funds based on equities are likely to perform worse than the general market, but they can offer protection in times of falling or slow-growth markets.
Despite the risky image of hedge funds and the fact that it can be hard to find out what the actual investments are, a growing minority of charities are looking seriously at the product.
Annabel Gillard, assistant director at Baring Asset Management, says there are different degrees of risk depending on the particular hedge fund: "You can get hedge funds with low risk and, by combining them with the rest of an investment portfolio, a charity can reduce its overall risk."
Many fund managers recommend that charities, particularly small to medium-size bodies, do not invest in single hedge funds, but in a fund that pools 20 to 30 hedge funds, known as a "fund of funds".
An advantage of this approach is that if one of the hedge funds in the pool collapses, the investor's exposure is limited.
The Charity Commission says investing in a fund of funds can reduce risk but stresses that hedge funds remain a complex form of investment for which expert advice is essential.
The commission did, however, approve the first common investment fund investing in hedge funds, Cazenove's Absolute Return Trust for Charities.
Since the launch of this fund of funds last December (see box and graph, over), it has attracted investment of more than £30m from more than 50 charities. By the end of June, it had reported a return of 6.1 per cent compared with the 2 per cent return for charities during the same period reported by research company WM.
Guy's and St Thomas' Charitable Foundation is one charity that has moved into hedge funds. It hired an investment consultant to look at its portfolio last year and, in an attempt to increase diversification, the consultant recommended some investment in hedge funds.
"We invested 4 per cent of our portfolio, about £10m, in hedge funds earlier this year," says finance director James Varley.
The charity's hedge fund portfolio was built by Fauchier Partners, a firm that also advises Cazenove on its hedge fund CIF (common investment fund).
Guy's and St Thomas' hedge fund portfolio is a more conservative and low-risk fund, says Varley. "Hedge funds bring up all sorts of ideas about betting on futures markets and so on, but that's not what we're doing," he comments. "In a well-structured hedge fund portfolio it's a way for a charity to achieve diversification."
This is because one of the key ideas behind hedge funds is that they offer a low correlation with other investments, such as equities and bonds.
In other words, because they behave in a different way to traditional markets, they offer some protection when those traditional markets are weak. This means, in theory, that they can provide charities with more stability in their investment returns.
But there are still a number of issues that charities considering hedge fund investment need to take into account.
One is complexity. "It's easy for trustees to understand what they're doing if they buy shares in Glaxo or ICI, but hedge funds are much more complicated," says Nicholas Orr, head of charities at Schroders.
Baring's Gillard agrees: "With equities, it's clear that they are a portion of a company and if the company and the economy do well, so do the shares. But it's harder to generalise with hedge funds and there are 14 different hedge fund strategies and within each strategy a huge range of managers and styles."
Because of this, Gillard says, it is important for charities to use a fund manager who understands the hedge fund market and can distinguish between the huge variety available.
The complexity is added to by the fact that many hedge funds only give out limited information about the details of what they are invested in.
Another issue is that fees tend to be higher than for traditional investments and will often incorporate an additional performance-related fee on top of the usual management charge. Another barrier to some charities is the fact that hedge funds do not pay income.
But because charities have such a high proportion of their investments in equities, often up to 85 per cent, they are having to consider alternative investments such as hedge funds.
"Many trustees are rethinking whether they want to hold as much of their portfolio in equities and are looking to reduce volatility," says James Saunders Watson, head of charities at JP Morgan Fleming.
Edward Harley, a Cazenove director, says a key attraction of hedge funds is that they aim to offer an "absolute return". This means that, unlike traditional investment portfolios, they are not just attempting to outperform a benchmark but actually to produce a positive return even when markets are falling.
Harley says: "If the equities market falls 20 per cent in a year and your fund manager tells you how well he's done because your portfolio has only fallen by 18 per cent, you're not going to be that thrilled."
He argues that even though the stock market seems to have regained some stability after three years of negative returns, there is still a place for hedge funds.
"Hedge funds are still attractive in today's environment even though markets are not falling. They might lose some attractiveness if people expected a three-year bull market for equities but I don't know anyone who's predicting that."
James Varley of Guy's and St Thomas' Charitable Foundation agrees that hedge funds will continue to gain in popularity as trustees become more familiar with their wider investment freedom under the Trustee Act.
But the UK is probably a long way from the situation in the US, where charities are more likely to have large hedge fund holdings. There is a cultural divide between US and UK charity investors, says David Bailey, vice-president of the charities team at Deutsche Bank. He notes that US charities, particularly academic institutions, often have up to 40 per cent of their investments in alternative investments such as hedge funds.
The more aggressive style of many US charities is unlikely to cross the Atlantic soon. Here, charities investing in hedge funds usually limit their stake to 5 or 10 per cent of their portfolio.