THE influence of hedge funds over the City has grown as quickly as investors’ money has flowed into the funds over the past 15 years.

These funds now reportedly manage over £750bn of clients’ money and their highly-paid managers can achieve remarkable returns.

Retail investors have so far been barred from investing in the funds, but that could change next year. But what are these funds and what makes them so different to normal collective investments? Read our report to find out.

What is a hedge fund?

Hedge funds are collective investments that aim to make money whether the market is moving up, down or sideways. Unlike unit trusts, Oeics or investment trusts, which tend to only grow when shares rise, hedge funds can make money when share prices are falling.

They do this using a range of complicated specialist techniques. The most commonly used is by going long or short on a share. Most private investors simply go long on a share, buying it in the hope that the price will rise.

Where an investor goes short, they believe that the equity will fall in value. There are two main ways that hedge funds can do this. The first is by ‘shorting’ the stock, where the investor ‘borrows’ a stock to sell it, with the hope that it will decrease in value so they can buy it back at a lower price and keep the difference.

For example, if an investor borrows 500 shares of X company at £10 each, they would then sell those shares for £5,000. If the price then falls to £8 per share, the investor would buy the shares back for £4,000, return them to the original owner and make a profit of £1,000.

Another way of taking advantage of falling share prices is by dealing in ‘contracts for difference’. This allows the investor to make money on share price movements without actually buying the shares. A CFD on a company’s shares will specify the price of the shares when the contract was started. The contract is an agreement to pay out cash on the difference between the starting share price and when the contract is closed.

However, hedge funds are not only restricted to equities. They will invest in anything that will make them a profit, including foreign currency, bonds or commodities. The return achieved by the fund is likely to be dependent on the skill of the manager rather than underlying economic conditions and that is why they are so well paid.

Can I invest in a hedge fund?

At the moment, hedge funds are only available to high wealth individuals who are prepared to invest around £500,000 or to professional investors, such as pension funds or insurance companies. Individual retail investors cannot buy directly into hedge funds as the City watchdog, the Financial Services Authority, is concerned about how the funds are operated and their risk. Plus, it is unclear whether the hedge fund operators would welcome dealing with a large number of small investors due to the costs involved.

However, the FSA will launch a consultation next year on whether it should increase the scope of funds it authorises to include funds of hedge funds. Retail investors still wouldn’t be able to invest directly, but would be able to invest in an authorised collective investment scheme that would put money into hedge funds.

Currently, if investors want exposure to hedge funds they can purchase shares in the companies that operate funds, such as Man Group. It is also possible to buy into foreign funds over the internet, although investors cannot expect the same financial protection that they would receive in the UK.

This is Money’s fund coverage and advice

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