As we have seen, derivatives allow you both to hedge your portfolio, by profiting from falling markets, and to enhance your returns, by margin payments and gearing. But there are other instruments that offer these benefits, too.
Hedge funds
Hedge funds are designed to produce consistent, absolute returns in all market conditions. And because they have low correlations with equity markets, they are an excellent way to diversify your portfolio.
The main advantage they have over traditional equity funds is the ability to short stocks, effectively borrowing shares to sell into the market in the expectation that the price will fall, then buying them back at the lower price. This means hedge funds can make money in falling markets. However, this is just one of many strategies employed by hedge-fund managers. The others do not all involve complex, technical derivative plays. Many use simple mergers and acquisitions, and pricing anomalies across different markets, for example - strategies used by traditional fund managers that are familiar to most investors.
On paper, hedge funds are a very attractive, low-risk investment. However, in practice, you need to be careful.
For a start, simply finding out about them can be tricky. There are literally thousands to choose from and nearly all are based offshore. They are not, therefore, regulated by the Financial Services Authority (FSA). You will need to factor in currency fluctuations, and bear in mind that any gains you make will be taxed as income. And you need a lot of money to access hedge funds - typically around $100,000, although you will find some willing to take a lot less. Worse still, many of the most successful, and therefore the most popular, are closed to new business.
All these reasons mean that, for the vast majority of individual investors, buying an individual fund is not a sensible option. A far better way to gain exposure to hedging strategies is to invest in a fund-of-hedge fund (see table). These are easy and cheap to buy, and employ dedicated professionals to pick the best individual hedge-fund managers. Dexion Absolute is a popular choice and has a consistent record of solid outperformance. It is, however, trading on a premium of 1.8 per cent. Thames River Hedge has the best record of all listed funds-of-hedge funds, returning 50 per cent in the past three years. Unsurprisingly, it is trading on a premium of 3.2 per cent.
Structured products
Conventional structured products offer capital protection and enhanced returns, combining a fixed-term bond to provide security with options for market exposure. For example, 90 per cent of your investment buys a bond, which should enable your initial investment to be returned in, say, three years time. The remaining 10 per cent would then be used to buy options to provide outperformance.
Some providers set a cap on the amount you can make over the life of the product, while others limit your participation in the growth of an index. Good structured products offer a higher participation rate than 100 per cent of the growth of an index.
More complicated structures are also available, although these can be rather confusing. For example, some products do not offer full protection of your initial investment, so you could lose money if the underlying index fell below a predetermined level.
Some products base returns on the index level at the end of the term, while others take an average over the final six months or year. Different products are also treated differently for tax purposes - gains are sometimes taxed as income, meaning that you cannot take advantage of your annual capital gains tax allowance.
One downside with using structured products is that you miss out on dividend income. Another drawback is that these are fixed-term products, so you cannot time your exit to coincide with an index's peak and there could be a capital loss if a product had to be sold early (on death, for example).
However, synthetics - structured investment trusts - can be traded during their lifespan, allowing you to take profits, although capital protection only applies to the initial price, not the current price.
For more on all types of structured products, including a comprehensive list of all those available to UK investors, go to www.structuredretailproducts.com.
Take note
One type of structured product launched recently is Barclays Investment Notes, which offer geared exposure to an index, a group of indices or a basket of commodities, with capital protection. Like synthetics, these notes are listed on the London Stock Exchange, which means that there is a secondary market for your note should you want to sell it before the full term has expired. For more on Investment Notes, go to www.stockbrokers.barclays.co.uk.
