Although there are technical differences between the two types of fund, they are identical from an investor's point of view. Investment trusts also pool investors funds, but they issue a fixed number of shares that are bought and sold on the stock market. Investment trusts are therefore not included in the FT Managed Funds Service.

The main advantages of managed funds are that it is possible to gain exposure to the capital markets by investing small amounts of money - as little as £20 a month in some funds - and that they can provide automatic diversification for investors because they invest in a range of assets. Funds can be held within Individual Savings Accounts, allowing investors to avoid capital gains tax and income tax.

The wide spread of investments lowers the risk of investing in the stock market because it gives investors some protection against the impact of a small number of holdings in individual companies performing badly at the same time. Investing in more than one fund increases portfolio diversity.

Funds also allow investors to put their money into funds managed by specialists, and to devote part of their portfolio to investments that may be risky, but offer potentially high returns, such as emerging markets, commodities and smaller companies.

These can be "tracker" or "passive" funds, which seek to replicate the performance of an index such as the FTSE 100 or the FTSE All Share, or actively managed funds, whose managers use their skills to invest where they think returns are likely to be highest.

Actively managed funds break down into two further categories - growth funds, which try to identify companies whose shares are likely to increase substantially in value, and income funds, which concentrate on finding companies whose dividends are likely to be above average. Some funds combine the two approaches.

Funds are tightly regulated, open to all investors, aim for a relative return (beating the rest of the sector, or an index), are not allowed to charge fees related to performance, cannot go short (selling shares they do not own in the expectation of buying them back later at a lower price) and cannot undertake heavy borrowing.

Funds are established, promoted and administered by fund management groups, some of which run very large numbers of individual funds. The assets of funds are held by an independent authorised firm, known as a trustee or depository, which oversees the operation of the fund.

They are managed by specialists, many of whom have built up expertise in a specific fund management area. Some of these managers have become very well known. Several organisations offer ratings for fund managers operating different sorts of funds such as corporate bond funds, North American equities and so on.

The best known rankings are provided by Citywire, at www.citywire.co.uk, and Bestinvest, at www.bestinvest.co.uk. It is worth remembering that managers sometimes move between funds, and that the performance of a particular fund may be affected by a change of manager.

However, most people should take advice before investing. There are two ways to do that - you can either talk to a tied salesman for one of the fund providers, or you can discuss your investment plans with an independent financial adviser.

The third way to invest is through a funds supermarket or discount broker. A large number of these can be accessed via the internet (try entering "funds supermarkets" into a search engine).

Both discount brokers and IFAs use funds supermarkets to locate and purchase funds, but going direct to the supermarket may not save you much money. This is because supermarkets generally rebate only part of the upfront fee, and none of the annual management fees you will be charged. Buying direct from the company or through a tied salesman will also incur full upfront and annual fees, unless you are taking advantage of a special offer.

Investors can usually decide to invest either a lump sum or smaller amounts in monthly instalments. Most funds will have a minimum lump sum investment of £500 or more, with a minimum monthly instalment of £50. Some will have higher thresholds for both lump sums and instalments, but it is possible to invest in funds for as little as £20 a month.

If you have available cash, you will benefit from investing in a lump sum if markets move in a favourable direction because your money will have been invested at the lowest possible average price - that is, the price of the fund's units or shares on the day you invested. On the other hand, of course, your losses will be greater if the market moves against you.

For this reason, there is much to be said for a regular investment plan. This stops investors trying to anticipate the market, which few have the skills or experience to do successfully, and ensures that they continue to build up their investment in the fund regardless of short-term swings in valuation.

Regular investment, also known as drip-feeding, can also reduce investment risk by smoothing the impact of swings in prices. This effect, known as pound cost averaging, occurs because the same amount of cash will buy more shares if prices have fallen since the last regular investment, increasing the potential gain when prices start rising.

Many investors combine the two approaches by investing a lump sum at the beginning and then undertaking to make regular investments in addition.

Investors looking for low cost funds should watch out for CAT marked funds. This is a government scheme that identifies funds adhering to rules on charges, access and terms. These funds must offer Individual Savings Account wrappers with an annual management fee of no more than 1 per cent of the fund value.

All or most of the upfront charge will go to the financial adviser or sales person who recommends or sells the fund. The remainder is kept by the fund. A few fund groups offer "no load" funds, which levy an exit charge rather than an upfront charge. This is imposed when an investor sells shares or units in a fund, and usually falls over time as an incentive to investors to keep their holdings.

The annual charge covers the cost of running the fund, including things like administration, brokerage costs (what the fund pays to buy and sell shares) and management fees (covering payments to the specialists who decide and executive the fund's investment strategy).

Actively managed funds are usually more expensive because investors are paying the costs of extensive research into companies and remuneration for specialist stock-pickers. Passive investments should be cheaper, although they still have to be administered and cover the costs of buying and selling stocks to remain in line with the composition of the index it is tracking.

These costs are not trivial for small investors, and they can amount to substantial sums for those with large holdings. However, it is worth remembering that achieving a similar level of portfolio diversification by buying individual shares and bonds would be much more expensive because the investor would have to bear the full cost of brokerage fees, and might have to purchase shares in large blocks because of restrictions on trades in small parcels. Only the very wealthy are likely to have sufficient assets to follow such an individual strategy.

Morningstar, the mutual funds research group, estimates that a private investor in a relatively concentrated fund with holdings in about 40 companies would need to invest about £40,000 in direct shareholdings to replicate the diversification benefits that can be achieved within the fund for a few hundred pounds www.morningstar.co.uk.

Like individual shares and bonds, investments in funds can be held within Individual Savings Accounts, though only within investment limits set by the Treasury. Holding funds within an Isa boosts returns because most income and all capital gains are exempt from tax. Higher rate taxpayers benefit most.

The value of units and shares rises or falls in line with the investments the fund holds. Many unit trusts have been converted to OEICs in recent years. Neither are listed on the Stock Exchange.

Unit trusts and OEICs invest in cash, bonds or equities and investors can generally buy or sell their investment through a fund manager on any working day. Investors who buy a unit trust or OEIC directly may use a "fund supermarket" or a "discount broker", which frequently operate on the internet.

One of the main differences between a unit trust and an OEIC is that unit trusts have two prices - buying and selling prices known as offer and bid prices. The offer price is generally higher than the bid price. OEICs have a single price and they may have different classes of shares for different investors.

Unit trusts and OEICs typically have an initial charge of 5 per cent, plus an annual management fee of up to 1.5 per cent. They are open-ended funds, unlike investment trusts that are closed-end. This means they vary in size according to whether funds are being invested or withdrawn.

Unit trusts and OEICs are authorised by a regulator and are subject to rules designed to provide investor protection. The assets are held by an independent authorised firm, known as a trustee or a depository. Most funds available in the UK are authorised by the independent regulator, the Financial Services Authority and are covered by the Financial Services Compensation Scheme.

Some funds are authorised elsewhere in the European Union such as in Dublin or Luxembourg.

In general, an investment trust's share price fluctuates in line with the value of its investments, but the two do not always match. The share price can be influenced by other factors, such as investor demand and market sentiment. If the share price is below the value of the assets, it is said to be at a "discount" to the net asset value. If it is above the net asset value, the share price is at a "premium".

An investment trust is structured like a company, with an independent board of directors. The fund manager reports to the board.

Investment trusts can do certain things that unit trusts and OEICs cannot. For example, they can borrow money to invest - this is called gearing, or leverage. Gearing can mean that exceptional gains are made during market rebounds, when it is often difficult to move quickly enough to get invested and the prices of stocks are rising very quickly. Gearing can also magnify losses in falling markets.

Investment trusts are closed-end funds, unlike unit trusts, which are open-ended. This means that they have a fixed number of shares.

ETFs combine some of the advantages of investment trusts and unit trusts. Like a normal share, trading takes place throughout the day while unit trusts offer only a daily price. Unlike an investment trust, ETFs do not trade at a discount or premium to net asset value but trade close to the underlying value of their net assets.

ETFs can be bought or sold through a stockbroker, and no stamp duty is payable on purchase. Dividends run in line with the sectors they replicate net of management fees. They can be put into an individual savings account (Isa), or self-invested personal pension (Sipp). Fees are lower than those of many trackers, and generally range between 0.1 and 0.65 per cent.

They can also promise a specified return at a specified time. The guarantee is usually met through the use of financial instruments, such as options, which offer the potential to protect the overall investment. To pay for the guarantee, investors agree to a cap on the amount they receive in the event of equity markets rising. This means it is unlikely that guaranteed funds will grow as fast as non-guaranteed funds when the stock market is performing well.

Guaranteed funds have a set life, and are a type of structured product, although not all structured products are guaranteed. An example of a guaranteed product is a guaranteed income bond, where an investor buys a single-premium bond from a life assurance company. The bond has a fixed term, and the investor is promised a return of capital at a pre-determined date in the future plus, over the term, a pre-determined amount of income on specific dates.

An example of a guaranteed fund that invests in the equity market is one that offers a fixed-term investment based on a particular stock market index, at the end of which time the original capital is returned regardless of what has happened to the market over the period. Any additional return will depend on the index's performance.

Some structured products, such as so-called "precipice bonds", do not offer a guaranteed return of the capital invested.

Millions of people use the funds to build up pensions or repay mortgages. Their asset allocation varies, with the proportion of assets held in shares ranging from zero to 75 per cent, according to Ned Cazalet, the respected insurance analyst. The rest is largely in bonds and cash, while some companies invest in commercial property.

For a conventional with-profits policy, the payout is typically made up of the basic sum assured, the annual bonus, which cannot be taken away unless you cash in early, or during adverse stock market conditions. Part of the payout also comes from the terminal bonus, which is not guaranteed and will not be known until the policy proceeds become payable when the investment matures. There is no price that investors can check to see how the fund is doing.

A recent briefing note by the Institute of Actuaries warned that payouts would continue to fall, partly because the outlook for future returns remained lower. To protect investments, it seemed likely that companies would cut pay outs faster than had been normal.

The funds invest in a range of asset classes, including equities, bonds, and property. The amount invested in shares varies, ranging from a maximum 35 per cent in the "defensive managed" sector to 100 per cent in the "stock market managed" sector.

Currency exposure also varies. The defensive managed sector requires funds to have at least 85 per cent of assets in sterling-denominated investments, while the stock market managed sector asks for only 50 per cent.

Investors can usually check the funds prices daily, although pricing is more infrequent for property funds.

Unit-linked funds are the vehicles into which investors money is likely to go if they buy unsmoothed pensions or other investments from life assurance companies. Charges vary among different products.

International equity funds tend not to hedge their currency exposure, so they are unlikely to be appropriate for investors who cannot afford to take foreign exchange risk. If the currency markets moved against them during the period in which they invested, they could lose out. Such investors might believe that they should have their assets denominated in the same currency as their liabilities.

People who are sceptical about the need to buy international funds would argue that investors can get exposure to international economies by investing in UK funds, which buy shares in British companies that trade worldwide. Against that, others would argue that investing internationally enables people to diversify their portfolios. If one market falls, investors losses might be offset by gains made elsewhere.

There is a sectoral issue - investors who keep their money in the UK would struggle to get significant exposure to the automotive sector. By investing overseas, they could potentially benefit from any increase in, for example, carmakers share prices.

Advocates of the funds could argue that they give investors exposure to sectors that are under-represented in their portfolios. However, one danger is that investors who buy sectoral funds concentrate their risk, instead of diversifying it. If shares in the relevant industry's companies fall, the money invested in the sectoral fund would drop. A £1,000 sum invested in the average technology and telecoms fund turned into £383 in the three years to the end of 2003, according to data company Moneyfacts.

Investors might prefer to get exposure to sectors by picking broadly-based funds. A UK fund would be likely to include banks, oil companies, drug groups and telecoms operators.

The costs of sectoral funds are sometimes higher than fees for broadly based funds. The average annual management charge in the technology and telecoms sector is 1.6 per cent, above 1.23 per cent in the UK All Companies sector, says Moneyfacts.

Some funds in this sector have outstripped broadly-based unit trusts. In the five years to the end of 2003, the average UK smaller companies fund turned £1,000 into £1,460, according to Moneyfacts, a data company. That beat the average fund in the UK All Companies sector, which turned £1,000 into £940.

This outperformance is no exception - between 1955 and 2003 the HGSC index returned 16.1 per cent a year including dividends, beating the FTSE All-Share index (12.7 per cent).

But the excess returns may reflect the illiquid nature of small companies shares. For the smallest - those with a market capitalisation below £5m a share trade takes place just once every 25 days. Even for those with capitalisations between £20m and £40m, a trade happens only once every five days.

The outperformance may also reward investors for the greater risk of buying smaller companies shares. In theory, smaller companies, which have narrower ranges of products and customers, are more likely to go bust than multinationals. The average annual charges imposed by UK smaller companies funds are 1.65 per cent, according to Fitzrovia, a data company.

Some of the biggest funds hold bonds issued by more than 100 companies, which reduces the potential loss to investors if an individual company fails to pay interest or repay capital. Rising interest rates will make the fixed income offered by bonds less valuable, relative to other investments, and that will reduce the bonds prices, exposing investors to the risk of a capital loss.

The fall in prices, does, however, make buying bonds cheaper, and raises the yield - the fixed interest as a proportion of the price. That makes bonds more attractive to new investors, providing a market for holders who wish to sell.

The average UK corporate bond fund turned £1,000 into £1,103 in the three years to the end of 2003, and the mean management charge is 0.92 per cent a year, according to Moneyfacts.

Another distinctive feature of hedge funds is their ability to borrow and invest the proceeds. They can also charge performance-based fees. Hedge funds are not yet authorised in the UK, and if the funds collapse, investors are unlikely to be entitled to compensation.

Investment strategies vary but macro hedge funds can take bets on currencies, depending on their managers views about the relevant economies prospects. Equity market neutral funds will buy shares in one company that they think is cheap, while matching their exposure by selling shares in another company that they think is expensive.

Investors should note that performance figures for hedge funds as a whole can be misleading because they relate to hedge funds which are closed to new investors.

Such funds invest at least 80 per cent of investors money in British shares and aim to have a yield equivalent to at least 110 per cent of the FTSE All-Share index. The average fund in the UK equity income sector turned £1,000 into £1,019 in the five years to the end of 2003, according to Moneyfacts. That beat the UK All Companies sector, where the mean fund produced £940.

The average yield in the equity income sector is 3.59 per cent, above 1.55 per cent in the UK All Companies sector, where funds put at least 80 per cent in UK equities and aim primarily at capital growth.

Value contrasts with the growth investment strategy, which had its heyday in the late 1990s, when investors were ready to pay high prices for shares in the hope that earnings would rise fast.

Their employers may set certain trade limits and provide all sorts of support services but it is the manager who picks the fund's investments. Star fund managers, whose esteem is often the result of stellar returns, enjoy public recognition and often attract investors on the basis of their reputation alone.

But if you choose a fund because of the manager then you may be faced with the dilemma of what to do if the star manager leaves a fund or decides to take a back seat. With managers moving between the different companies ever more rapidly - just a third of funds investing in Britain have been managed by the same person for the past 10 years - it can be hard to keep up.

Companies are keen to poach successful managers once they have established a good track record. There have also been a lot of mergers and acquisitions in financial services, which quite often lead to changes, as managers dislike their new working environments.

If you choose to follow the manager to their next fund this can be costly and time consuming because some managers move every few months. Moving between management houses also involves a lot of disruption, and the manager may not perform so well without the team they have left behind.

There is the pressure of stardom to consider too. Companies best people are often required to give talks at conferences and to take an active role in marketing their funds. This leads to a danger that they take their eye off the ball and the performance may slip.

However, many in the industry believe that gifted managers deserve their loyal following. They suggest that the team approach, where a number of managers work together on decisions, shows a lack of confidence in individual skills and a fear that money will leave with any departing manager.

But a manager's importance will vary depending on the type of fund he or she is running. At one end of the scale there are "tracker funds", in which the manager's input is heavily limited. At the other are the "actively managed" funds in which a manager's judgment is one of the most important ingredients.

There are a string of other issues to consider when choosing a fund. Investors should think about the design of the fund, what the fees are and what sort of risk controls it has. The most important thing to look at is what the fund sets out to achieve and whether that objective suits your needs.

The cult of the star manager has also focused the spotlight on past performance figures - particularly because high returns are often attributable to one person's stock-picking expertise. In these situations, investors should beware - they may be looking at a "ghost performance" achieved by long- departed managers.

The City watchdog, the Financial Services Authority (FSA), has banned firms from "cherry picking" information to show past investment performance in a flattering light. They are concerned that firms are using the best periods of a managers past performance to promote funds and suggest that historic returns are a measure of what investors may get back in future.

From June this year, all advertisements that refer to the past performance of investments must also include a standardised table showing the annual returns for the same fund for the past five years. These figures must be expressed as a percentage, and should, the FSA hopes, "give consumers a better understanding of the volatility of the investment".

However smart you are the unexpected always happens, so you should guard against being wiped out in a single catastrophe by spreading your risk across several funds, or by choosing a fund manager with an investment strategy that is in line with your goals.

At a very basic level investors face a choice between two basic types of funds, those designed for capital growth and those that produce current income. Growth and income funds both invest in equities, but they usually perform differently.

Income funds invest in shares that pay above-average dividends, and tend to do relatively well in a downturn when investors want the security of a decent payout. Growth funds, which tend to chase short-term trends such as the tech bubble in 1999, usually perform better in a market upswing. Advisers suggest a blend of both in your portfolio.

Broadly speaking younger people are saving for the long term and don't necessarily need their investments to produce a current income but will be looking to guard against inflation. Under these circumstances advisers say growth funds are usually best; these aim to provide a growing capital sum, usually at the expense of a high current income.

For middle-aged investors, growth funds are still normally the right thing, but the amount invested is likely to be larger as a result of higher income and savings accumulated over previous years. With a secure capital base behind them, middle-aged people may also consider putting part of their savings into some of the more risky investments such as some of the more specialised pooled funds.

When investors start to approach retirement, their priorities change. Having built up a capital sum they will need to start switching towards funds that will provide an income once they stop work. Retired people are also less able to take the knocks that can come from growth funds - for although share based investment funds tend to do well over the long term, they can swing in value over the short term. So people of that age will start to switch into income funds.

A good place to start trying to match the stock market's performance is with a general UK equity fund that will tend to invest in a broad range of UK shares. For those looking for slightly more risk growth funds will try to beat the market. Not all parts of the stock market perform equally well at the same time, so the trick is for the manager to pick the next boom area. In pooled investments there are many funds that concentrate on specific types of share - for example smaller companies or technology stocks. If the manager picks the right area, they can beat the market, but at the risk of under performing if the decision is wrong.

One area liked by fund managers seeking growth is recovery funds. These are funds investing in shares which have fallen on hard times, but which are not expected to go bust; as the companies recover from their difficulties their shares can do very well.

Another group of funds that try to beat the index are so-called special-situations funds. These invest in unloved, under-researched companies, and can be risky. There are always likely to be companies that are undervalued and managers who can spot their recovery potential.

It is important not to be swayed by fashion. If a particular area of the stock market or an overseas market is doing outstandingly well, a number of new funds will be launched to exploit the boom. Plenty of hype goes into these new launches but this may not last long.

Passive managers buy and hold portfolios that are designed to replicate the market, or a large proportion of it. By buying each stock in an index, or a broad representation of the stocks in an index, passive managers generally deliver returns that match their index, so in theory at least there will be no nasty surprises.

In contrast, active managers seek to build portfolios that outperform a market benchmark, usually through a combination of stock selection and market timing. In some years, some active managers will succeed in outperforming their benchmark, while others will fail.

So why would anyone settle for the average returns of passive management when they can obtain above-average returns by selecting above-average managers?

Passive investing proponents argue that markets are efficient - that is, that the market takes into account all the available information about any particular security and price it accordingly. So they believe there is little room to take advantage of mispricing because prices already reflect true value.

But the proponents of active management argue that the market is not completely efficient, allowing smart investment managers to best the market. And a number of managers clearly do so every year. But as the availability of information increases every year, say passive managers, so the efficiency will increase and it will become more difficult to beat the market.

Passive investors also cite the laws of arithmetic. It is a given that the average return of actively managed portfolios will equal the return of the market. It is impossible for the majority of investors to outperform the market so half of these funds should beat it and the other half should under perform it. If you add in the costs of trading, administration and management fees, fewer than half of actively managed funds can possibly beat the markets over time.

The key advantage of active management, the potential to beat the market, is only useful to individual investors if they consistently choose the winning managers. With no systematic, reliable way of ensuring that your choice of active manager will outperform the market, in the end you have to gamble on who you think will deliver the best returns.

It must be remembered that costs matter. Paying a total expense ratio of 2 or 3 per cent when equity returns are 8 per cent effectively wipes out the equity premium. This reinforces the need to choose managers who will outperform.

The costs of passive funds are low because the fund is not being "actively managed". But there is still an element of manager risk. Tracking methods vary, ranging from full replication - holding every stock in the index in proportion, to partial replication - holding a sample of the index, in order to reduce dealing costs. Timing of buying and selling can also affect performance.

Despite these differences, when you choose the passive route you know in advance that you will receive a return approximate to section of the market the fund is tracking. Over time, this has been a good return. And, as the studies show, the much lower costs of tracker funds will ensure that they will generally beat two-thirds of actively managed trusts.

If you choose an actively managed fund you will have to monitor the fund's performance, and make sure you are not left hanging when a star manager leaves. It is true, though, that passive funds are not as flexible as their active counterparts, and do not have star managers who can hop nimbly out of share that looks as if it is about to fall off a cliff.

Investors who pick funds by choosing those at the top of the performance tables are making the basic investment mistake of getting in at the top, when most if not all of the growth potential for a particular sector or area has been realised.

Even if the approach is more sophisticated, perhaps choosing the top performing fund in an out of favour sector, academic research shows that outperformance, whether of a stock market index or an average of competing funds, rarely persists. Even where it does, there is no way of predicting in advance which funds will achieve it consistently.

Fund providers have taken to promoting fund managers, as much as the funds themselves, on the basis that their performance is a better indicator. Fund managers often move around, so it is more useful to track how they have performed at their various jobs than to check the record of a fund that may have had several managers over the period in question.

But there is no more evidence that fund managers can produce consistently good performance than there is that funds can, or that those who have done well in the past will continue to do so. Or even that the performance record can be attributed to one individual rather than a team.

Even so, investors may decide to put their faith in a particular manager. There are a few who appear to have done very well for their investors over long periods. The best known is probably Warren Buffet, the Omaha-based investment guru who runs the American investment vehicle Berkshire Hathaway.

There is no comparable figure in the UK investment industry. The nearest contender is probably Anthony Bolton, who has been looking after investors money at fund manager Fidelity for over 24 years. Even he was distinctly unfashionable for a period in the 1990s when the technology boom was in full swing, and Bolton's value approach to investing was out of favour.

Specialist publisher Citywire (www.citywire.co.uk) and advisory firm Bestinvest (www.bestinvest.co.uk) both publish fund manager performance figures for those persuaded that this is useful information.

Investors looking for a more informed approach to choosing a good investment recognise that the performance record of a fund should come some way down the checklist. Right at the top are the issues of risk and charges.

A fund will only be a good investment if it fits with an investor's aims and requirements, and complements any existing investments.

Assessing the risk level of a fund is not always straightforward, and there is no standard approach to the risk labelling of funds. It is up to managers how they do it, or whether they do it at all. The Financial Services Authority has not tackled this aspect of fund information either, restricting the information it provides on its website (www.fsa.gov.uk/tables/) on individual savings accounts (Isas) mainly to charges.

One website that does offer risk rating is FT Fund Ratings (http://funds.ft.com/funds), which ranks funds by risk, charges and performance, with five different risk levels.

The risk level of a fund is measured by its volatility, or the tendency of a fund to rise and fall rapidly and unpredictably in price. FT Fund Ratings categorises funds with an average weekly change in their price of up to 8 per cent as very low risk, while those that move by more than 27 per cent are very high risk. The former category is restricted to money market and bond funds. The latter includes technology funds and US small cap funds, for example.

Charges are also an important element in fund choice. A fund with high charges will have to grow faster than one with lower charges to provide the same return. So it makes sense to choose low cost funds wherever possible.

Funds held in an Isa are sheltered from capital gains tax, and the income they generate is completely free of tax at best and sheltered from higher rate tax at worst. The treatment depends on whether it is income from fixed interest bonds or shares.

The investment limits for Isas may seem low, at £7,000 a year to April 2006 then £5,000. But putting in the maximum each year can soon add up, and couples can double up.

There is some confusion over whether Isas are still worthwhile, because of tax changes from April 2003. The 10 per cent tax credit on dividend income from shares can no longer be reclaimed by Isa investors from then. This makes equity Isas income tax neutral for basic rate taxpayers, who are also unlikely to benefit much from the capital gains tax shelter, as few will even use up their annual capital gains allowance.

But fund managers argue that it still worth putting equity funds inside an Isa - investors can grow their money in the Isa, will not have to declare it to the Inland Revenue on their tax form, and can convert it to fixed interest to pay a tax-free income when they need to start drawing on their investments.

Higher rate taxpayers will still avoid an extra tax charge on dividend income by holding equity funds inside an Isa. But they will get a bigger income tax benefit from holding bond funds. Isa investors can reclaim the 20 per cent tax withheld on interest from fixed interest bonds, and higher rate taxpayers escape paying an additional 20 per cent tax.

Investors can buy funds already wrapped in an Isa direct from fund managers, but will get a wider choice by using a fund supermarket. Alternatively, they can use a self-select Isa where they can mix funds with directly held equities. These are available from execution only brokers, such as Comdirect and Hargreaves Lansdown, and from other providers such as investment trust manager Alliance Trust. But investors should take a close look at the services on offer and the cost structure before signing up.

Self-select Isa providers also often offer self-invested personal pensions (Sipps), another type of tax-efficient wrapper. These offer freedom to invest in a wide range of assets, including commercial property, with the added fillip of tax relief on money going in and a tax-free growth environment. Investors can take 25 per cent of the fund as a tax-free lump sum, but will have to pay tax on their pension income.

Sipps are not usually an option for members of occupational pension schemes, who are not allowed to contribute to individual pension plans unless they have another source of income. But planned changes to the rules, expected to come into force from April 2005, will give more flexibility.

In the meantime, investors can contribute £2,808 a year on behalf of non-earners and children, which is made up to £3,600 by basic rate tax relief contributed by the government.

Investors who do not belong to an employer's scheme can currently pay in a proportion of their earnings, ranging from 17.5 per cent up to age 35 to 40 per cent for ages 61 to 74. Under the government's proposals, these limits will go in favour of a lifetime limit of £1.4m on the size of the pension pot and an annual limit of £200,000.

Alas, achieving those tasks is incredibly difficult. The data suggest that very few managers are able to outperform a widespread basket of shares (an index fund) over the long run and even those who do may be lucky, rather than skilful. And the evidence also suggests that very few investors are able to time the markets; naturally enough, since it is only when investor enthusiasm is greatest that market tops are reached.

But that does not stop people from trying. Fund managers try to beat the indices because that justifies their fees of up to 1.5 per cent a year. And retail investors try to both to pick the best fund managers and to find sectors that are due to rise in price.

For both, the task is daunting. There are over 2,000 quoted companies on the UK market alone while UK investors have the choice of almost 2,000 unit trusts and open-ended investment companies (OEICs).

Most fund managers claim to be able to pick stocks on the basis of a thorough examination of the prospects and the managements of the companies concerned. But clearly it would not be practically possible for a UK manager to keep track of more than 2,000 companies.

Some thus take short cuts; they follow an investment style of one kind or another. The two broad groupings are known as value and growth. The divide is not clear-cut; presumably growth investors do not look for poor value shares and value investors would like to see some growth.

But nevertheless, there are two different mindsets at work. Value investors are looking for businesses that have been mispriced, perhaps because the market has become unduly pessimistic about the company's prospects. They thus may be looking for companies trading on a low price-earnings ratio, low price-to-book (asset value) or high dividend yield.

Growth investors are more concerned about finding a company with excellent prospects, whether it is in a growing industry (eg mobile telecoms in the 1990s) or it has a dominant brand (Coca-Cola for much of the 20th century). They are, within limits, less concerned about price, believing that rapid profits or dividend growth will justify an above-average valuation.

These very broad approaches have their own subsets. Some investors look for earnings revisions, buying those shares where analysts are rapidly upgrading their forecasts. An aligned school is that of momentum investors, buying shares that have recently been rising in price on the grounds that trends, once begun, tend to persist.

Arguably the most successful investor of all time, Warren Buffett, combines features of both the growth and value schools. He learned investment from Benjamin Graham, the founder of security analysis and the doyen of the value school. But over the years, he decided that a pure Graham approach led to the acquisition of too many cigar butt stocks, good for one last puff and no more.

As a result, Buffett changed his methods. At heart, he believes that investors should look at a company as a business; if they are willing to buy a single share, they should be just as willing to buy the whole business. That mentality prevents the investor from acquiring shares in failing businesses that look cheap. Instead, Buffett looks for companies with brands or unique franchises, such as the Washington Post, that earn substantial returns on equity; he then hopes to hold those shares forever.

Buffett and many other fund managers still seem to regard stock-picking as an art; the right decision can be made by experienced judgment, following a thorough analysis of the fundamentals. But some fund managers take a more scientific approach, using a computer to crunch through the data in search of pricing anomalies.

Enhanced indexation is a system that takes small bets relative to the index, based on computer analysis, that aims to produce better returns than the index, at relatively low risk. It is becoming increasingly popular among institutional investors.

These computer-based approaches are sometimes dubbed black box models. Their obvious potential flaw is that, if one examines any batch of historical market data, it is possible, with sufficient analysis, to find some strategy that worked. This does not prove that the same strategy will work in the future; the success in the earlier period could simply be due to chance.

Some approaches, however, may work over a longer period. Ex-academic Robert Fernholz, who runs a fund management company called Intech, tries to find stocks with high volatility but low correlation. Imagine one could find two stocks that were equally likely to halve or double over the following year but were negatively correlated. The investor puts 100 into each.

At the end of a year, Stock A will have doubled to 200 and stock B halved to 50 (or vice versa). The total value of the portfolio will have risen to 250. Leave the portfolio unchanged and the chances are Stock A will halve back to 100, while stock B will double to the same level; leaving the investor no better off after two years. But rebalance the portfolio every year and the volatility should work in the investors favour.

There is no automatic reason why such an approach might break down, although there is always the danger that volatilities and correlations can change over time.

Some believe it is possible for investors to use sophisticated techniques to time the markets, switching out of equities and into bonds. Clearly such an approach could have been enormously successful has investors, say, sold equities in March 2000 and bought them back again in March 2003.

Most timing approaches use traditional valuation measures such as price-earnings ratios, dividend yields or asset values. The US stock market undoubtedly looked very high on such measures in March 2000. Unfortunately, it had also done so for much of the previous three years. Investors who sold in 1997 would have missed three years of a roaring bull market.

Some academics believe there is clear evidence of reversion to the mean - that high valuations are followed by low returns and low valuations by high returns. There has been some evidence of this in the US market, if one looks at measures such as the cyclically adjusted price-earnings ratio or the ratio between stock market capitalisation and the replacement cost of the corporate sectors net assets.

But this may not apply to all markets. Elroy Dimson, Paul Marsh and Mike Staunton looked at the relationship between dividend yields and market returns and found that, except in the UK, they had little value as a predictor.

The perfect market timing device remains a Holy Grail, something that can be visualised but not grasped.

The term soft commissions refers to the practice whereby brokers or investment banks supply fund management groups with services, in return for which the fund manager agrees to devote a portion of its commission income to buying shares through the broker.

A classic example might be that the broker agrees to pay for the use of several Reuters or Bloomberg screens. In return, when the fund manager has a big purchase order for Vodafone, he will route it through the broker.

What is in it for the client? Cost savings. Without soft commissions, the cost of those Reuters and Bloomberg screens would come directly out of the manager's revenues. Instead, the service is effectively paid for by the end client, the pension fund or unit holder. The broker benefits from getting order flow, which may help the firm's traders to assess supply and demand in the market.

The problem, however, is that this is not a very transparent process. Why should a client pay for a service when the cost should clearly be borne by the fund manager? After all, it is not always necessary for fund managers to pay commission; they can deal directly with market makers or use a crossing service, which links together institutional investors. And there is a danger that fund managers may churn the portfolio, trading excessively so that brokers can be recompensed for the services they have supplied.

The Financial Services Authority's consultation paper 176 proposed that soft commissions should be banned and that the costs of brokers services should be unbundled - so that clients pay for them separately. This would imply that brokers and investment banks would have to make an explicit charge for research.

Fund managers seem to accept that soft commissions have had their day. The system is not as abused as it once was - Wimbledon tickets were once offered in return for commission income - but it is hard to justify in ethical terms.

In contrast, the industry has reacted with horror to the unbundling proposals. In essence, they feel that the FSA is using a sledgehammer to crack a nut. Research conducted by Oxera, the consultancy hired by the FSA to study the issue, found that total commission costs were just 14 basis points. Of this, only 1 basis point related to soft commissions and 3 basis points to research. In contrast, stamp duty costs 50 basis points and the market impact on trading is around 60 basis points.

Fund managers also argue that there are perfectly valid reasons for bundling together research with broking. For a start, there are economies of scale associated with the investment bank research model. There are perhaps 20-30 significant banks and brokers. They can talk to quoted companies, sift the information available and then pass it through to end investors. It would be enormously more costly and time-consuming if companies had to deal with many thousands of investors, all seeking information for themselves.

Secondly, if fund managers are forced to pay directly for research, they will limit the amount they buy. This will cause a decline in the amount of research being conducted, particularly at the small cap end of the market. The stock market will become less efficient.

In any case, the industry argues that the current system does not really have any ill effects. Fund managers (and therefore the end client) often have to pay commission anyway, whenever they trade in stocks. Since it is the responsibility of the broker to conduct the deal at the best possible price, the client is not losing out.

Furthermore, if the fund management group did have to pay for research, what then? Fund managers could try and absorb the costs within their profits but after the bear market of 2000-2002, many are barely profitable. This would be a bad time to impose an additional cost burden.

Of course, fund managers could try to pass on the clients in the form of higher fees. If they were successful, then clients would be no better off than if the reforms had not occurred in the first place.

But fund managers worry that they would be unsuccessful. In particular they fear that they would lose out in the competition for international business. UK fund managers would be bearing these costs but their rivals in the US and Switzerland would not. Some have threatened to leave the UK altogether if this reform goes through.

Few would argue that, if the world were starting from scratch, it would be sensible to adopt the current system. It is clearly not ideal for analysts to work in an investment bank; the conflicts of interest caused have been widely exposed in recent years. There has been a bullish bias in terms of both share price recommendations and, until the last year, profits forecasts.

It is also odd that fund managers seem so attached to analysts when they claim to be selling their own stock-picking skills to clients. Why should clients pay active fees if the work is really being done by Merrill Lynch?

Some fund managers, of course, employ their own analysts. They presumably incur additional costs not borne by their rivals who use the free product of brokers and investment banks. One would think they would be keen to see unbundling but there is no sign that such managers have separate views from the rest of the sector.

Unbundling ought to benefit the independent analysts, those not employed by an investment bank or broker. But they are not too keen about the FSA's proposals either, since the majority of their money comes in the form of soft commissions.

So few people seem very happy with the FSA's paper. The FSA is now researching whether the international arguments (the threat that fund managers will move overseas) make sense. If it sticks to its guns, prepare for an almighty battle.

In practice, there has been a distinct lack of progress towards a single market in investment funds, and most investors still buy local funds from local providers. In most European countries, the market share of foreign investment funds (by asset share) rarely exceeds 20 per cent. The only fund centres to be able to claim significant cross-border sales are Dublin and Luxembourg, and that is more to do with their low tax nature than anything else.

Yet the fund industry believes there are real economic benefits to be gained from achieving a truly single market for asset management. The Investment Management Association, the trade association for UK fund managers, quantifies the benefits at 0.4 percentage points a year, which could increase the overall size of a pension by about 9 per cent, or 120,000 euros for the average investor.

Fund managers claim they could achieve these benefits if they were left to their own devices and allowed to compete on equal terms with cross-border rivals. But they say they have been thwarted by regulatory, fiscal and structural barriers that reassert local markets over the single market.

Another problem is that the legislation is always a step or two behind market developments. The original Ucits Directive, which laid down the rules for the type of fund that could be sold across borders, restricted the single market for investment funds to straightforward equity and bond products.

It has since been updated, most recently by Ucits III, which expands the product list to include money market, index tracking and fund of funds products and allows Ucits funds to use derivatives as part of their investment strategy. But critics say key growth areas remain excluded.

The changes have not addressed the inclusion of property or hedge funds, for example, which managers say would ensure consumers were being offered the broadest possible choice.

Others, taking the consumer side, say consumer protection is not given a high enough priority. The Ucits III directive is a welcome step forwards on this front, as it includes a requirement for fund management companies to be authorised and introduces a simplified prospectus, which should help investors understand what they are buying.

But some commentators suggest that, while the changes under Ucits III recognise fund choices that have been standard within domestic markets for years, giving managers the freedom to use derivatives and gearing within Ucits funds may not be a step forward for consumers.

Derivatives used to enhance performance could cause problems, they say, and gearing means investors can lose money, perhaps all of their money, faster than in an equity fund.

Costs are also an issue. In an ideal world, European-based fund management companies would lower the costs of their products, which are higher than those in the US, and make them attractive to investors across the continent. But to do this they need to restructure their business in ways that are difficult to achieve under current rules.

Tax is another problem, and perhaps the biggest hurdle inhibiting the development of a competitive single market for investment funds. Control over direct tax remains with member states, which leads to a number of discrepancies.

Governments can apply different or discriminatory tax rules to foreign-based Ucits, such as the 1984 offshore taxation legislation introduced to prevent UK investors gaining tax advantages from investing in offshore roll-up funds. It made gains on such funds subject to income tax, making them less attractive than UK-based funds.

Another approach is to give tax relief, but only for investment in domestic funds.

Discriminatory tax regimes can be challenged in the European Court of Justice, but it is a slow and cumbersome process. Fund managers want an overhaul of this area to produce a step-change in the ability to sell funds on a truly pan-European basis.

There are hopes that the introduction of the European savings directive will result in a more transparent environment for the European fund industry to operate in, and result in additional pressure to reduce existing tax barriers.

There are other barriers, through, including the different registration requirements in different member states, disparities in accounting and advertising rules, and different approaches to the way funds are sold.

The Ucits Directive has created a standardised product, which is a vital first step to creating a single market. Ucits III is a further step in the right direction, but there is still some way to travel before investors and fund managers reap the benefits of a single European market for investment funds.

UK investors may become more familiar with the Ucits label under new rules for UK investment funds the Financial Services Authority plans to introduce, although they will not come in for all funds until 2007.

The regulator plans to rationalise the eight different categories of UK retail investment funds into two broad types. These will be a Ucits type, where the spread and quality of investments will be limited to those allowed under the Ucits Directive, and a non-Ucits type that will be able to invest in a wider range of assets, including property. The former may be passported in the EU, meaning that they may be offered to investors in states other than the home state of the provider.

But big changes are afoot. After more than a year of consideration and consultation, the FSA is about to approve a pared down regime that will introduce a more flexible framework with a new range of fund choices for investors.

The replacement rule book will be little more than half the size of its predecessor, which had grown haphazardly over more than a decade in response to market developments. The regulator says it will be a less prescriptive blue-print for the future that can accommodate developments in the fund management industry and the different levels of experience and expertise of investors.

The move towards change began in May 2003, after PwC, the professional services firm, conducted a review of the current framework. The consultants concluded that there was demand for a wider range of funds for the retail market than the rules allowed.

The essence of the changes, expected to be given final approval in late March, is the creation of a two-tier system that would distinguish between expert and institutional investors on the one hand and retail investors on the other. The FSA says its current one-size-fits-all regime, under which all authorised funds can be sold and marketed publicly to all investors, is no longer appropriate.

As the FSA put it in consultation document CP 185, "The UK fund industry operates on a two tier basis - institutional and retail funds. The participants in these funds have different needs and risk profiles. For example, many financial institutions, such as insurance companies and pension funds, need an authorised product to invest in, but most will be more experienced and have greater expertise than a retail consumer."

When the new rulebook takes full effect in 2007, there will two kinds of retail funds - those that are compatible with the European Union's Ucits Directive (Undertakings for Collective Investment in Transferable Securities), which creates a minimum harmonization of rules to encourage cross-border investing, and those that are not.

In most respects, these non-Ucits retail funds would be required to operate in the same way as Ucits funds. They would, however, be allowed to invest in property, which is an asset class barred to Ucits funds. The regulator says its new regime will remove "artificial constraints on developing such funds for retail investors".

The regulator also plans to change the rules on redemptions for non-Ucits retail funds that invest in substantially property or have an objective of providing a specified return over a period.

Although the details have yet to finalised, it is expected that these funds will be allowed to limit redemptions by investors to once every six months. This compares with the requirement for Ucits funds that investors must be able to redeem their units at least twice a month; in practice, daily dealing is normal for many Ucits funds. Funds that restrict the right to redemption in this way would have to make clear to investors at the time of sale that their money would be locked up for periods of up to six months at a time.

Alongside these two classes of retail funds there will be a third class of authorised funds known as non-retail funds, which will be available only to market counterparties and intermediate customers - those who are professional, high net worth or sophisticated investors.

These funds will give investors access through authorised funds for the first time to a new range of investment strategies such as going short (selling stock that they do not own to buy it back more cheaply), taking on high levels of debt, using derivatives and investing in commodities. Many constraints remain, however. The funds will not be allowed, for example, to let debt or exposure to derivatives exceed net assets.

The introduction of these funds is a significant step towards a more disclosure-based regime under which managers of funds sold to expert investors will be given more freedom to operate in the UK in exchange for providing more information. The theory is that institutions and professional investors do not need the same protection as private investors. At the same time, investors and regulators will get more information about such funds through the process of authorisation and regulation.

All funds are to be given the freedom to levy performance fees instead of, or alongside, fixed or percentage fees. Performance fees, which would reflect the success or failure of funds based on the performance of unit prices, are permitted elsewhere in the EU, which means that they can already be marketed to UK investors. The FSA says there are no investor protection reasons why it should not liberalise its rules on fees, while investors could benefit "from the ability to choose a product that does not take an ad valorem fee irrespective of performance".

The changes will also cut down unnecessarily prescriptive rules and make the regime fit modern practices and consumer demands. The FSA is, for example, proposing to streamline information given to investors on funds. It is also cutting down on the bumph sent out to consumers, who will receive a short report on a fund unless they specifically request a full report and accounts.

Managers will be required to consult investors only on fundamental changes to a scheme, such as a change in its objectives, and will be able to notify them of minor changes, rather than going through a long process of consultation. In addition, the regulator is abolishing the requirement that funds list prices in at least one national newspaper. Instead, fund managers can make prices public "in an appropriate manner".

Underlying all these changes is a desire on the part of the regulator to give investors more choice and investment managers in the UK more flexibility to compete for business against funds based offshore or elsewhere in the EU. The FSA is scheduled to approve rules allowing the new funds at its board meeting in March, although the rulebook will not come into use in its full form until 2007.

What exactly is a hedge fund? The entity was invented by a man named Alfred Jones who had the idea that investors could, as well as picking shares they believed would rise in price, select those that were likely to fall. These shares would be sold short with the investors borrowing them and selling them with the aim of buying them back at a lower price. Such long/short funds would rise in value, regardless of overall market movements, provided that the investors stock-picking skills were good.

The original aim was thus rather conservative and a far cry from the speculative image hedge funds hold today. But that image is rather unfair. Hedge funds come in many different categories - some risky, some conservative.

Hedge funds will have some or all of the following characteristics; they will be based offshore and virtually unregulated; they will have small groups of investors, usually rich individuals or institutions; they will aim for an absolute (positive) rather than a relative return; their managers will be incentivised by a performance fee; they will have the ability to go short; they will have the ability to use leverage.

The contrast with unit trusts or mutual funds is stark. While they can be based offshore or onshore, such open-ended funds are tightly regulated, open to all investors, aim for a relative return (beating the rest of the sector, or an index), will have no performance fee, cannot go short and cannot use leverage.

The greater freedom afforded hedge fund managers has its pros and cons. While it (in theory) enables them to make money in all sorts of markets, it can lead to disaster - witness the collapse of Long-Term Capital Management in 1998. But the performance fees and the lack of regulation attract many talented fund managers, who believe that the hedge fund structure represents the best chance for them to become rich.

The standard picture of a hedge fund manager is that of George Soros, the man who broke the Bank of England. Soros's Quantum fund reportedly made $1bn speculating that sterling would be forced out of the Exchange Rate Mechanism in 1992.

But Soros is a decidedly atypical hedge fund manager. For a start, he has courted publicity; writing books and commenting on politics (such as his dislike of George W Bush). Most hedge fund managers like to remain in the shadows. Soros is also a macro manager, a type of hedge fund that takes big bets on a wide variety of themes, from currencies through to equities and bonds. Most hedge fund managers are far more specialised.

Evaluation Associates Capital Markets, a US group that monitors hedge fund performance, divides the hedge fund industry into five broad strategy types and 13 sub-strategy styles. The broad strategies are relative value, event-driven, equity hedge, global asset allocators and short sellers.

The relative value group has subsets comprising long/short equity specialists, convertible hedgers, bond hedgers and multi-strategy managers. The event driven group has three subsets - deal arbitrageurs, distressed debt specialists and multi-strategy event driven managers.

The equity hedge group comprises domestic long-biased, domestic opportunistic and global/international managers. Global asset allocators (the Soros-style macro funds) come in two types - systematic traders and discretionary managers. The short selling group only consists of managers who sell short US equities.

All these different hedge fund managers are pursuing quite different goals. So any statement that says hedge funds did well (or badly) last year needs a lot of qualification. Short-selling funds, for example, performed well in 2002 but poorly in 2003, for obvious reasons.

Broadly speaking, most hedge fund strategies tend to under perform equities in sharply rising markets and outperform in flat or falling markets. But all statistics in this area need to be treated with caution. Harry Kat and Gaurav Amin of the University of Reading have found that two-fifths of hedge funds fail to survive for at least five years. That suggests there may be significant survivorship bias in the performance data; only the best funds will be recorded.

It is easy to see why hedge funds give up. They may start with a small amount of seed money and hope to add more if performance is good; a good record will also mean that the managers earn performance-related fees. But if the record is poor, no new money will be attracted and performance fees will not be paid. It will simply not be worth it for the fund manager to continue.

Another problem for the aspiring hedge fund investor is that the most successful funds tend to be closed to new investors. Many hedge fund managers feel that there is a limit to the amount of money they can successfully invest - this may be particularly the case if the manager specialises in a niche area, such as merger arbitrage.

In addition, hedge fund results tend to have fat tails, in other words there are more extreme results than would be expected. The risk is that the hedge fund investor picks just one or two funds, and then suffers a very negative fat tail.

Many investors accordingly opt for a fund of funds route, paying another manager to sort through the hedge fund universe. This has some advantages; funds of funds find it easier to do due diligence than the average investor; they can sometimes gain access to closed funds, because they are already investors; and they allow investors with smaller sums to participate.

The disadvantage, of course, is that the investor ends up paying two sets of fees. Given that fees on the underlying funds are already high, this may eliminate the benefits of investing in hedge funds altogether.

British investors can put money into hedge funds, but the funds are not allowed to market themselves in the UK, and they are not authorised by the Financial Services Authority. This means that investors are unlikely to be eligible for compensation if something goes wrong. Most hedge funds are based in jurisdictions such as the Channel Islands and the Caribbean. That is why they are referred to as offshore funds.

But as hedge funds have become more accepted around the world as mainstream investment vehicles, this has come to be seen as an anomaly. After lengthy discussion, the Financial Services Authority has decided to fill the gap with a new class of authorised hedge funds.

This liberalisation follows moves across the EU to allow hedge funds greater freedom to set up onshore, prompting fears that the UK was losing out to other regimes, notably Ireland, Germany and Luxembourg. If some outstanding issues, such as the tax rules, can be sorted out, the change in the regulations is expected to prompt rapid growth in authorised UK hedge funds - not least because the UK is already home to about 70 per cent of hedge fund managers.

The new funds will not be available to all investors. They will be classed as "non-retail" funds, which means they will be restricted to institutions and sophisticated or professional investors - those that the FSA thinks have sufficient understanding and expertise to understand the risks of the product.

"Our general view is that investors in these funds do not need the same level of protection from our product rules as we aim to deliver in retail funds. We expect them to be willing to accept a higher level of risk and to have more experience and expertise than retail customers," the FSA says.

"We consider it important, however, that product regulation for these funds should provide sufficient protection for non-retail investors to differentiate them from unregulated funds and to provide market confidence in this new type of product."

What this means is that the funds will have much more freedom to develop investing strategies than retail funds (standard unit trusts and open ended investment companies, and a proposed new class of non-Ucits funds that can invest in property), but will have to meet some basic rules designed to ensure that they act prudently.

For example, although the funds will have much greater freedom to invest in a spread of assets, they will have to satisfy the FSA that they have diversified properly to reduce the risk of a catastrophic collapse.

They will be allowed to use derivatives based on financial instruments and commodities, but the funds liabilities through derivatives will be limited to the net assets of the fund. Borrowing will also be allowed, subject to a maximum limit, although this may also be as high as 100 per cent of net assets.

They will be able to invest in property, but not in a single building. Gold and other commodities will be allowed as investments, along with traded commodities contracts, but funds will be prohibited from taking physical delivery under derivative, forward and commodities contracts.

As in traditional managed funds, all investors will have an effective right of redemption, but the timetable may be limited as long as it is explained in the fund's prospectus. Price calculations will be covered by a similar prospectus requirement, freeing non-retail funds from the detailed prescription of calculation methods imposed on retail funds.

A new funds rulebook being developed by the FSA is expected to be approved at a board meeting March (2004), and it will then become possible to establish authorised hedge funds along these lines, even the rulebook does not become mandatory until 2007.

In practice, however, few such funds are likely to be established until the Inland Revenue agrees to substantial changes in the tax rules relating to hedge funds.

Under the current tax rules, gains arising in hedge funds are categorised as trading income, and the Revenue taxes notional gains on a yearly basis (even if the fund's income cannot cover the tax liability).

This makes the UK an inhospitable home for hedge funds, whether authorised or not. The FSA said in May 2003 that it was working with the Revenue to change the rules, but the Revenue has yet to consult publicly on the changes that would be needed.

The FSA has admitted that few funds are likely to be launched without a change in the tax rules, but is hopeful that some progress will be made shortly. "If at some point the Revenue does fall into line then funds will start to be set up," the regulator says.

"Authorisation of these funds provides an assurance of a certain quality of regulation and operation. Many investors, including sophisticated investors, value this," the FSA says. It should also cut costs to investors and encourage new entrants into the funds marketplace.

"Under the present [rules], the prescription and lack of flexibility in some areas may have caused increased costs for authorised fund managers. This in turn may have meant that charges to investors are higher than they could be."

The FSA also claims that the introduction of authorised hedge funds may have a knock-on effect on the wider investment market because they will be competing for funds with the life assurance companies, which are not subject to detailed product regulation.

However, the regulator's main hope is that the new class of funds will provide a significant additional outlet for UK investors, which will help to protect the leading position of the City of London as a financial market from the threat of competition from elsewhere in the EU.

"Other jurisdictions already provide a regulatory regime for funds for sophisticated investors. Permitting this in the UK will facilitate competition with those non-UK funds," the FSA says.