How's this for a sales pitch: we're going to take your money and invest it in an almost indescribably complex way. Some of our strategies may be similar to those that caused the infamous 1998 collapse of Long Term Capital Management, an investment house saved by a $3.6 billion injection from a collection of the financial world's biggest companies and the intervention of the U.S. Federal Reserve Bank. Oh, and don't forget: we'll help ourselves to commissions of up to 20% of your gains, our products are barely regulated, they're not registered with the U.S. Securities and Exchange Commission (SEC) and we're not obliged to report publicly where your money is going or how it's doing.

Sound risky? It is. So why are mainstream investors lining up to buy into so-called hedge funds, the esoteric investments that used to be the province of the superrich? For one thing, retail investors are tired of traditional mutual funds that tread water or worse. For another, respected firms like Man, a U.K. hedge-fund giant, are now marketing their products to people who have as little as $18,000 to invest. Although estimates vary, earlier this month the Alternative Fund Services Review, an industry publication, claimed that assets under management in hedge funds had surpassed $1 trillion. Another analysis firm puts the figure at more than $860 billion — up from $456 billion five years ago. To be sure, hedge funds still account for less than 1% of assets under management worldwide. But a Goldman Sachs–Russell Investment Group study released in 2003 forecast that the percentage of European institutions investing some part of their portfolio in hedge funds will rise from 21% in 2003 to 50% in 2005.

What's the attraction? Huge returns. In 2003, hedge funds globally returned an estimated 13%, with a projection to do the same this year. That's more than double the projected return for equities. "We're looking for solid returns," says Malcolm Gray, finance director of Railpen Investments, the investment arm of Britain's Railways Pension scheme, which last month said it would invest $1.1 billion in hedge funds. "We think the price of bonds is too high; we're worried about the price-earnings ratios of equities. [With hedge funds] we want to get some absolute income in."

Yet even though the interest of big institutional funds has enhanced hedge funds' respectability, experts encourage investors to tread warily. The market has grown so quickly that some commentators are comparing the hedge-fund boom to the dotcom bubble. While the best funds do make lots of money, they generally require a long-term commitment from investors. And the lack of consistent and transparent strategies among various hedge funds doesn't help. Says Ian Morley, CEO of Dawnay, Day Olympia, a joint-venture asset management concern: "Hedge funds are many things, and hedged isn't usually one of them."

Hedge funds originated in 1949, and were for many years the province of the hyperwealthy, who used them to protect assets during market slumps. Some of that high-net-worth legacy still remains — in the U.S., investors wanting to invest directly in a single hedge fund must have $1 million worth of assets, and $200,000 in annual income. They were designed to hedge against market movements, and thus while they mostly hold the same assets as traditional vehicles — a mix of bonds, stocks, cash and property — they use much more aggressive investment strategies, like short selling, where an investor seeks to benefit from declining market prices; derivatives, where an investor uses instruments derived from the price of an underlying financial asset; and arbitrage, where an investor tries to exploit price differentials between markets. Flat stock markets have meant dwindling returns for institutional investors, who have been forced to seek other ways to plug the shortfalls in their portfolios. In addition to Railpen pledging $1.1 billion to hedge funds, earlier this year British Telecommunications' pension fund said it planned to invest $895 million. Says Railpen's Gray: "We're trying to diversify. We're here to secure our pension promise."

The enthusiasm has rubbed off on retail-fund managers, who usually sell hedge-fund exposure to the general public via products known as "funds of hedge funds" — diversified baskets of pure hedge funds. But that still doesn't mean funds of hedge funds are for everybody. Man recently launched a U.S. fund that requires investors to plunk down $25,000. Man's first sterling-based fund, launched last month in association with Close Fund Management, requires a minimum investment of about $18,000, and you can't pull your money out for eight years without paying an exit fee.

Funds of hedge funds have become so popular that they now make up about one-fifth of all funds. In addition to Man, the other big players include the U.S.-based Permal, with $16.7 billion in assets under management. Increasingly, there are tools investors can use to help them pick which funds of hedge funds they choose; in addition to hedge-fund indices already compiled by Dow Jones and Morgan Stanley, Standard & Poor's has launched a new European-based ratings service for funds of hedge funds. James Tew, Standard & Poor's head of fund ratings, says the new service is vital "in a market not known for transparency."

For those who can afford to play, the hedge-fund game can be worth it. But if something goes wrong, investors have little redress. "Hedge funds might raise $1 million in funds, and then borrow another $9

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nginx/1.14.0 (Ubuntu) million off the back of that," says David Eacott, a spokesman at Britain's Financial Services Authority (FSA). "So if the fund loses 10% of its value, then you've lost all your money." In the past five years, about 9% of hedge funds have gone out of business.

Thus, many governments are wary. Germany has only recently allowed hedge funds to operate within its borders. The U.K. regulates the companies that run hedge funds, but not the funds themselves, which tend to be based offshore. In the U.S., the sec is seeking to firm up rules for hedge funds, which are not compelled to reveal their holdings or strategies. "Big pension funds now put their money in hedge funds, and that means retail investors have an indirect investment," says one official. "There's too much money in [hedge funds] now for us to not know what is going on."

Some hedge-fund managers say if they are forced to disclose their trading strategies, they will lose their competitive advantage. Others complain that if hedge funds are allowed to take fewer risks, they will inevitably make lower returns. Says Narayan Naik, director of London Business School's Centre for Hedge Fund Research and Education, "Any regulation imposes costs." Unless there are harmonized laws, adds Naik, funds are likely to move about the globe, looking for lighter regulatory environments.

Still, investors keep piling in — and they are getting more help all the time. Next month, Britain's National Association of Pension Funds will host its first hedge-fund seminar for pension-fund trustees. Says investment manager Tony Price: "You need good advice. Hedge funds are an expensive business and you need quite a lot to break even. It takes a lot of expertise." When it comes to investing their money, investors should be sure to hedge their bets.

• JENNIE JAMES
• More average investors are taking the leap into these dicey, potentially lucrative funds