How would you define a hedge fund? According to Dion Friedland at fund of funds specialist Magnum: All hedge funds are not the same - investment returns, volatility and risk vary enormously among the different hedge fund strategies. Some, which are not correlated to equity markets, are able to deliver consistent returns with extremely low risk, while others may be more volatile than mu-tual funds. Many but not all hedge fund strategies tend to hedge against downturns in the markets being trad-ed. Hedge funds are flexible in their in-vestment options. They can use short selling, leverage, futures and options."

The argument for them within pension fund allocation runs that hedge fund strategies can be tailored to provide institutional funds with a more extensive range of income, growth and risk attributes than are available with traditional investments.

Much has been made of the potential for European pension funds to diversify their portfolios, but it is not clear how much potential there is for hedge fund managers at this stage. The familiar problems of perception and monitoring have to be resolved. The industry realises it has a problem, especially outside the US, which is why it has been so keen to see hedge funds known generically as 'alternative investments'.

The industry blames the cliched and largely inaccurate view of hedge funds as risky, technical and occasionally morally bankrupt vehicles, but in reality, less than 5% of hedge funds are so-called 'global macro' funds. Most use derivatives only for hedging, and many use no leverage.

According to Pierre Delandmeter, a member of the UK-based Alternative Investment Management Association (AIMA): "There is a large gap be-tween the US and European domestic figures for the use of 'alternative' investments. The 1997 figures for the number of onshore hedge funds are ap-proximately 670 for the US and 75 for Europe. In managed assets, the figures are $100bn in the US against ap-proximately $20bn in Europe. In the US there are more than 500 CTAs, in Europe there are just 50."

Hedge funds represent the equivalent of 5% of the US mutual fund market. If this is applied to Europe, all that can be said is that "Europe is only at the beginning of the growth stage in its life cycle", according to Delandmeter: "If the demand for European hedge funds follows the life cycle of mutual funds, the growth period may go well until 2005 and will represent a market of $150bn."

But this growth is unlikely to be driven by institutional demand, judging by current attitudes towards hedge funds. According to Intersec Research, 61% of European institutional investors use derivatives mainly for tactical asset allocation, but only 4% use structured derivatives strategies.

As Pierre Lequeux of BNP Global Markets notes, "An important aspect of investment performance is the predictability of returns over time."

Unfortunately for alternative investments, there is little evidence of predictability in average returns or in correlations with stock and bond returns. This is why fund managers such as Matthew Annable in the active equities division of Barclays Global Invest-ors see little need for pension funds to invest in hedge funds. Nor does he see demand increasing significantly: "I don't know of a single pension fund that uses hedge funds within its asset allocation. Pension fund trustees have to meet some pretty onerous requirements in terms of returns and risk. Hedge funds are ill-defined and often you won't know what exactly you're invested in at any time."

'The review of methodology and utilisation of alternative investment benchmarks and indices', was commissioned by AIMA as the industry's attempt to tackle the need for a credible benchmark. It still falls short of an agreed benchmark calculated by a recognised independent provider, but it at least gives a clearer definition of each asset class with guidance on suitable benchmarks."