The Financial Services Authority (FSA) is toying with the idea of authorising funds of hedge funds. This would effectively give the watchdog’s seal of approval for hedge funds to be sold to UK retail investors for the first time. But the fee-hungry City is beating the FSA to the punch.

A total of 21 funds of hedge funds have already raised £1.8 billion on the London Stock Exchange over the past 18 months, according to ABN AMRO, the Dutch investment bank. Though often registered in Guernsey, these funds, akin to investment trusts, are freely available to retail buyers, allowing them to gain access to a portfolio of hedge funds.

What may raise eyebrows with would-be investors is the charging structure adopted by these “closed-ended” funds. Many impose an annual management fee of between 1 per cent and 1.5 per cent of assets under management. What is unusual is that they often then take a performance fee on top, typically 10 per cent of gains made in the fund of funds.

This might not be so bad, except that the underlying hedge funds in which these funds invest themselves often charge a 2 per cent annual fee and a performance fee of 20 per cent of gains. The effect of this quadruple charging is that an underlying return of, say, 20 per cent could become little more than 12 per cent in the hands of the investor.

One senior figure in a London investment bank says that these funds are taking a big chunk of the performance, yet “basically they have been producing pedestrian returns at a time when the stock market has been quite strong”.

Naturally, the industry does not agree. James Freeman, of Key Asset Management, which runs funds of hedge funds, says: “Compared with traditional ways of managing money, where two thirds of funds fail to outperform the benchmark, hedge funds are good value.”

He cites his own firm’s Key Hedge, an open-ended offshore fund that has returned an average of 9 per cent a year for the past 17 years, without losing money in any single year. The problem is that few of the new London-listed funds have a consistent record that extends beyond three years, let alone to the last bear market. And that is a big test, because hedge funds do not typically claim to beat the stock market. Rather, they usually attempt to track “absolute” returns, aiming to beat the interest rate on cash, for example, and not losing money when stock markets fall.

Charles Cade, an analyst with Winterflood Securities, the broker and market-maker, believes that the fees can be worth paying for a fund that consistently generates a return better than cash. “You do have to pay high fees,” he says, “but a lot of the underlying funds are high-risk and very specialist. A private client should not be investing in them direct. We would regard funds of hedge funds as a much more suitable vehicle.”

Although he accepts the principle of performance fees, he warns investors to watch out for how they are charged. “Normally they charge a 1 per cent base fee and 10 per cent of any outperformance, but I believe that should be 10 per cent above the set target, not 10 per cent of everything once that target is hit,” he says.

Even so, Mark James, of ABN AMRO, believes that, for retail buyers, London-listed funds tick many of the boxes, including access to a wider range of underlying funds, daily pricing, frequent updates of net-asset value, Stock Exchange regulation and independent directors.

Crucially, the structure allows an investor’s profits to be taxed as capital gains, rather than income, which reduces tax bills for most people.

If the FSA proposals do result in open-ended funds of hedge funds coming to the UK, one model for the new funds is likely to be GAM Diversity. This $6.6 billion fund, based in the British Virgin Islands, has generated an average annual return of 12.4 per cent since it launched in December 1989.

It has handsomely beaten hedge fund indices and, more impressively, generated a full four percentage points a year more than the MSCI World equity index. And yet the only charge on the GAM fund is a 1.7625 per cent annual fee, with no performance kicker.

However, GAM Diversity is a realistic option only for sophisticated and wealthy investors. The rest of us will have to make do with its newer closed-ended imitators. Until they can show a track record through good markets and bad, most people should follow the advice of one hedge fund manager who candidly admitted that “most private investors would be better off in a long-only fund”.