Pension fund trustees should consider investing money in alternative investment products including hedge funds, according to the Irish Association of Pension Funds (IAPF). Laura Slattery reports

But the recommendation, made by IAPF chairman Mr Gerry Ryan, was followed by the warning that trustees would need to minimise the risk of getting involved in such comparatively new ways of making informed bets on the stock market.

Hedge fund managers, spurred by substantial performance-related incentive fees, aim to achieve "absolute" returns rather than simply beating prescribed benchmarks. They should not, the theory goes, use underlying market conditions as an excuse for negative returns.

Hedge funds have thrived through the recent period of market volatility.

The graph shows the performance over the past five years of a "fund of hedge funds", which is a fund where the return is based on an aggregate of at least 25 hedge funds.

The fund of hedge funds in question, the Absolute Alpha Fund, has performed more consistently than the Morgan Stanley Capital International World Free Index, which measures the equity markets.

Bonds have also generated stable returns. A heavy weighting in bonds over the past three years would have protected people who saw a large chunk of their retirement income wiped from their pension fund just as they were about to retire.

The catch is that, historically, bonds give a lower return over the long term than equities.

All of this will make hedge funds sound highly attractive to the pensions industry, which has been forced to re-evaluate its investment strategies following the dramatic losses over 2000-2002.

Hedge funds try to shelter investors from untimely market plunges, giving straight-line rather than alarmingly zig-zagging returns.

"If you're sitting in a pension fund trustee's chair, that is the kind of return you want," says Mr Dara Fitzgerald of Focus Investment Managers, a specialist hedge fund management company.

Companies offering hedge funds therefore argue that their reputation as risky investments is not deserved. Funds of hedge funds, in particular, are a diversified, conservative investment, they say.

Nevertheless, the IAPF's caution that trustees should take pains to minimise their exposure to risk does not come out of nowhere.

First of all, hedge funds often use a speculative tactic known as "short selling".

This involves selling shares it does not own in the expectation that those shares will fall. If they do, the fund will be able to buy the shares at a lower price and deliver them to the buyer at a profit.

But if the hedge fund manager gets it wrong and the shares rise, the fund manager could have to buy them at a higher price, then pass them on at a loss.

Another strategy employed is leveraging, which means using the hedge fund to borrow so it can take bigger bets. This can mean a greater upside, but it can equally lead to a more painful downside.

If a hedge fund is 2.5 times leveraged and the value of the assets falls by 20 per cent, then investors will lose 50 per cent.

Very few hedge funds use leveraging, according to Mr Fitzgerald. The Focus Global Fund can borrow within its terms and conditions, but it never has, he says.

"Hedge funds can be reasonably risk-averse; however, they are sophisticated so you have to to understand the whole concept of hedging," says Mr Ian Mitchell of Deloitte Pensions & Investments. "With pension funds, you're talking about institutional money, so trustees should be looking at hedge funds, there's no doubt about that," he says.

However, the industry is young, making performance data a less-than-reliable guide to long-term future returns, while differences between how the funds work mean they can be difficult to compare.

"It is still a highly unregulated sector," Mr Mitchell adds, noting the above-average charges on most funds.

"Alternative investment strategies are more expensive than traditional strategies because of the work involved in managing them," says Mr Niall Duggan, senior manager at another hedge fund provider, BDO Simpson Xavier.

Irish pension fund trustees are "only really getting started" when it comes to hedge funds, he says.

"In Ireland, we're behind the curve."