Nominal returns from both equities and bonds are expected to be low in the coming years.

The past two years have seen traditional fund managers deliver significant losses. So it seems only natural, in this climate, that investors' attention is turning towards hedge funds. For example, Hong Kong's Securities and Futures Commission has recently given retail investors the chance to buy hedge funds later on in the year. The move was designed to broaden investment offerings and boost Hong Kong's position as a fund management centre in Asia.

By employing, they claim, the best managers and by aiming for absolute rather than relative returns, hedge funds appear to deliver diversification benefits to a pension fund portfolio.

But is it that easy? Not according to Gaurav Amin and Harry Kat, of the University of Reading, who have been taking a long and sceptical look at the claims of hedge funds in a series of academic papers.

In their latest paper, Stocks, Bonds and Hedge Funds: Not a Free Lunch*, the academics admit that the inclusion of hedge funds within a portfolio can improve a fund's mean-variance characteristics - they can reduce the standard deviation of the portfolio return while maintaining the expected return.

But that is not the end of the issue. Hedge funds have unusual properties: their returns do not conform to the normal (bell-curve) distribution. Instead, their returns display "fat tails". In other words, there are more extreme events than an investor would normally expect - a statistical phenomenon known as "kurtosis".

Furthermore, hedge funds display negative "skewness" - the bell curve shifts to the left. So, there are more negative or low-positive periods than one would otherwise expect.

The academics experimented by adjusting a portfolio of equities and bonds to include various allocations to hedge funds.

They found the inclusion of hedge funds leads to:

* A higher probability of a very large loss.

* A lower probability of a smaller loss.

* A higher probability of a low-positive return.

* A lower probability of a high-positive return.

In summary, Amin and Kat say: "Most investors that use hedge funds for diversification will expect to trade in profit potential for reduced loss potential on a more or less equal basis. However . . . investors can expect to give up more on the upside than the downside."

The good and bad news is that these effects only come into play when a significant proportion of a portfolio is devoted to hedge funds - more like 25-30 per cent than the 1-5 per cent most institutions are considering. If you devote just a small proportion of your portfolio to hedge funds, you will not suffer from kurtosis, but nor will your risk/reward trade-off improve.

There is also a note of caution about that risk/ reward trade-off. Previous studies have shown that the monthly returns of hedge funds involved in convertible strategies show a high level of serial correlation - a 1 per cent return in one month is highly likely to be followed by a 1 per cent return the following month. This, the authors suggest, is because the kind of securities owned by the funds are illiquid - thus the managers may use the last reported transaction price for valuation purposes. This may make hedge funds look a lot less volatile than they actually are.

Furthermore, it is worth remembering that quoted hedge fund performance data tend to show a survivorship bias - poorly performing funds are quickly closed down.

What about investing in funds of funds? The academics are not encouraging. A paper published by Harry Kat and Sa Lu earlier this year and first reported in FTfm, found that, over the period 1994-2001, the average fund of funds underperformed an equally weighted portfolio of randomly selected hedge funds by almost 3 per cent a year.

This may all seem a bit too gloomy. But the academics have a good point.

"Hedge funds are not necessarily good or bad," they say. "They are just very different from what most investors are used to and require a more elaborate approach to investment decision-making than currently in use by most investors."

If pension funds are going to invest money in hedge funds, they are going to need to devote time to research - not just into the performance of individual funds, but into the effects of a given hedge fund allocation upon their portfolio structure. This may be feasible for the largest funds but for most schemes, the game is not going to be worth the candle. *Stocks, Bonds and Hedge Funds: Not a Free Lunch by Gaurav S Amin and Harry M Kat, ISMA Centre, University of Reading, contact h.kat@ismacentre.rdg.ac.uk Philip Coggan is the FT's investment editor. Contact philip.coggan@ft.com

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