Promoted as a risk-free and potentially lucrative route into the complex world of derivatives, capital-guaranteed hedge funds may be viewed by some investors as a panacea. But do these products standup to close scrutiny? Despite their increasing popularity in Asia and Europe, many money managers are loath to recommend them to clients. A guaranteed hedge fund allows investors limitedparticipation in single-manager or multi-manager hedge funds, while ensuring return of the capital investment over a prescribed period usually five years. Guaranteed funds can be structured in manydifferent ways but a typical fund would be invested in a combination of fixed-interest securities, such as zero coupon bonds, and a fund of hedge funds. If the hedge fund pool increases in value, theproportion of the portfolio’s exposure to this pool is raised. Conversely, as the value of the active pool falls, the percentage of the fund invested in it will need to be reduced to ensuresufficient zero-coupon bonds are held to cover the guarantee. So far so good. But there are potential pitfalls investors should be aware of, according to Colin McInnes of Berry Asset Management PLCin London. High bond yields are needed so that a decent proportion of the portfolio can be invested in the hedge fund pool in order to achieve a worthwhile return, he said. Then there are costs toconsider. As well as paying several layers of management fees investors will have to pay a fee, typically 1.5 percent, to the bank or insurance company that provides the guarantee.

If the active pool does well, investors should be well rewarded for their trouble. In a worst-case scenario, however, the portfolio could end up 100 percent invested in zero-coupon bonds. If this were to happen early during the investment term investors would still recoup their initial investment, minus the charges, but they would have been better off in cash. Also, with most capital-guaranteed hedge funds the guarantee only applies if investors remain in the fund until the end of the investment term. A spokesman for London- based investment advisers Towry Law said that investors should ask themselves why they need a capital guarantee in the first place. Funds of hedge funds tend to limit volatility by spreading assets over a variety of investment structures. If multi-fund managers can protect capital during one of the worst bear markets, it seems pointless paying for a guarantee to protect against downside risk, he said. Bridget Cleverly, a hedge fund adviser with the Matrix Group, a London-based firm that specializes in alternative investments, agreed that capital guarantees and risk-averse funds of hedge funds make odd bedfellows.

A sensible alternative would be to offer a capital guarantee on a fund that has significant upside potential, she said. Investors will be able to sleep at night and there is an opportunity to make a high return on their investment.

Matrix Group plans to introduce a capital-guaranteed hedge fund in May or June. The fund will be linked to the performance of a single-manager futures fund that has had a compound rate of return of 18 percent per annum. The portfolio split will be 50 percent futures fund and 50 percent cash with an 8-year investment term. The minimum subscription is to be decided, but it will be no less than l5,000 ($8,000) and no more than l10,000. In recent months, capital- guaranteed hedge funds have been introduced by New Star International and BNP Paribas. Minimum subscription levels start at around $10,000