Hedge funds aren't a new field, despite their relatively new look and feel brought about by the fact that it is only now that the big managers are offering them. The sudden increase in hedging activity may well be a result of the increases in market volatility we have seen over the past few years.

Every generation faces its own market crisis , in the 1970s the "nifty fifty" stocks collapsed and with it the reputations of most investment managers. The messiah at that time was Modern Portfolio Theory, I wonder perhaps are hedge funds today filling the same niche, because the promises are certainly the same.

When MPT came in the hype was the same as accompanied hedge funds today, scientific methods promised to bring higher returns and lower risk. We now know that MPT was never able to deliver on these promises and live up to its hype, I worry that hedge funds are now being looked to in the same way, and will perhaps ultimately lead to the same disappointments.

In the last decade there has been an explosion in public offer hedge funds, and as a result the average quality of management has fallen. Arbitrage spreads have been reduced as the market has been forced to become more efficient, and computers track virtually every conceivable investment idea, sending a buzzer off on some trader's desk to let them know an arbitrage opportunity is at hand.

Enthusiasts of hedge funds claim that in the future people will put half their money in hedge funds. I don't doubt that hedge funds are losing their risky image, but are the markets really so inefficient that we can invest half of our money in managed funds and the other half should be put toward arbitrage? Surely if hedge funds ever get that big the majority of hedge strategies will cease to work, since they all rely basically on finding gross inefficiencies in market pricing?

Hedge funds are a perfectly valid strategy, I am not saying that there is anything wrong with them as such, but surely their very popularity will be their eventual downfall? If hedge strategies grow at the rate their fans say they will we may get to the stage where arbitrage simply becomes impossible. What will we do then? All buy index funds I suppose, to capitalise on our nearly perfectly efficient markets.

I am reminded of Warren Buffett's words of wisdom, that at the end of the day the most money we will all be able to make, as a group, will be equal to what the listed companies make and pay as dividends or keep as retained earnings, and even then only if we all stop trading and and paying commissions and just buy and hold.

On the subject of commissions, fees tend to be very high with hedge funds. Even though many of them are performance based, the amount being taken in fees is staggering compared to standard sector and diversified options. If you're a person that complains about management expense ratios (MERs), the MERs for hedge funds will take your breath away. Of course these might not be such a problem because although the fees are steep, they do tend to be performance based, something like 15% of outperformance above the cash rate is typical. Such a fee structure would get the funds very focused on performance, including long term performance, which should be a novelty for many in the industry.

Caveat emptor, regulation and security checkups on the people involved might go some way to avoiding really dodgy funds that will perpetrate fraud (how do you know an unregulated offshore hedge fund you heard about on the Internet is not just a Ponzi scheme?? I would suggest avoiding funds that advertise via the Internet or at hard sell seminars), you can go through the big money management groups to reduce the risk of being scammed, but regulation by itself won't guarantee a good investment.

There are also tax issues to complicate things, and the Australian Tax Office may well start paying a lot more attention when they become a mainstream product offered for people's superannuation. I can see cases where extensive use of esoteric hedge products could bring up questions about whether or not the fund can continue being a compliant regulated super fund. This issue remains to be seen and it would be interesting to see what sort of determinations are put out by the Australian Tax Office and the Australian Prudential Regulation Authority (APRA) regarding what trustees can, and can't do with these investments.

As many hedge funds are based off shore, this introduces Foreign Investment Fund (FIF) tax implications. This means investors get taxed each year on an "accruals basis", meaning either the increase in market value of their investment, or on the basis of a deemed rate of return (now 9.86 per cent) applied to their investment.

Quite apart from tax complication, one might want to consider tax efficiency. Some overseas hedge funds get around FIF rules by liquidating their portfolio annually and distributing income to shareholders. Even funds that don't do that still tend to have very high turnover. The funny thing is that because of their poor tax efficiency hedge funds may not be suitable investments for people on high marginal tax rates, but considering the risks involved I wouldn't recommend them to low income earners either! If you do want to dabble in them, consider making them 5% of your superannuation portfolio, though of course if you are going to have such limited exposure to them they will have practically no effect on your portfolio!

One final gripe relates to liquidity. Many hedge funds only accept fund redemptions a couple of times a year, some incur lengthy wait periods or big exit penalties. Don't use hedge funds with money you might need to call on soon.

If you are going to use hedge funds, I believe you should do so only for diversification reasons. Due to their nature they could almost be described as a whole new asset class, much as venture capital and private equity are sometimes classed as separate, even though they are really equity (stock) investments. I don't suppose a 5-15% allocation in your portfolio of a blended hedge product would be an enormous risk, many widely held super funds are already looking at putting in 5%, and 20% is not uncommon in US funds, but due to the nature of these things where high profits are likely to be punctuated by occasional spectacular failures this is not a sector into which I would back up the truck.

With the number of large players bringing in hedge funds it is likely that minimum initial investment buy-ins will reduce over time. Hedge Funds of Australia already offer hedge investments for $5,000 minimum and apparently Colonial First State is going to get involved with a $1,000 buy-in. In addition many superannuation funds are starting to offer them as a portfolio choice, so your existing super may well offer you hedge exposure soon.