With the ISA sales season well under way the Financial Services Authority has issued a timely warning to investors to be aware of the potential risks associated with hedge funds.

Hedge funds gained fame and notoriety following George Soros's assault on the pound and its ultimate ejection from the ERM.

Hedge fund managers were viewed with a degree of mystique as large sums of money travelled the globe seeking out financial anomalies. These anomalies were then often exploited using opaque borrowings and a great degree of risk.

The question of risk management was brought to a head following the collapse of Long Term Capital Management in 1998, producing losses for the fund of £4bn and bringing the whole financial world closer to the precipice.

Though the industry remains loosely regulated, significant steps have been taken to improve their internal controls, the clarity of strategy and the transparency of their operations.

For the individual fund manager the ability to focus on specific strategies and to change tack quickly creates greater flexibility and the potential for greater returns.

The most typical type of hedge fund is one incorporating the ability to go short.

In simple terms, this allows the fund manger to sell stock that is not owned, which can be beneficial in falling markets, though can be extremely risky should market conditions improve. Other strategies include arbitrage and themes.

New hedge funds, and fund of funds, appear daily and are being launched by many mainstream unit trust managers to cater for the growing demand. However, supply can often create its own demand and hence the recent risk warning from the regulatory authorities.

The warning is timely, given we are in the middle of the ISA season and the marketing of the two products are often intertwined.

Within any balanced and diversified portfolio there can often be a place for the occasional high-risk investment, thought the risk should not be underestimated.

There is also the short-term danger that hedge funds become last year's technology funds.

John Pearson - Associate Director

l Gerrard is regulated by the Securities & Futures Authority. Share prices and the income from them can go down as well as up. Readers are advised to seek professional investment opinion before entering into dealings in securities mentioned in this article, which may be unsuitable in their personal circumstances.