Hedge funds may not be the obvious candidates to run electricity grids or barge fleets, but the race to generate ever greater returns is luring more of them to do just that.

Larger energy and commodities specialist funds are setting up so-called special opportunities funds to snap up infrastructure or positions in physical commodities markets.

Wherever you look, the trend is to move into the physical side of the business, said Gary Vasey at energy and utility consultancy UtiliPoint.

Large Wall Street banks, private equity firms and now hedge funds are jostling to acquire physical assets, he said.

Ospraie Management, a U.S-based hedge fund, earlier this year bought into a barge company in the United States, hoping to ride an expected boom in the need to transport commodities across the U.S. on barges.

U.S. hedge fund groups Adit Capital and Solius Energy Fund are among hedge funds that are reported to control more than 25 percent of the world's physical uranium stockpiles, hoping to profit from revived interest in nuclear power.

From refineries to liquefied natural gas (LNG) import terminals, barges to ships and oil tankers and dry ports, nothing seems to be off limits for these financial players.

Centaurus, Saracen Energy ... they were founded as hedge funds to trade energy. (But) if you poke under the covers, you will find they are in the physical side of the business, added Vasey.

MORE INSIGHT

Analysts and industry officials say hedge funds are finding that owning a physical asset allows them more insight into the market, giving them an extra trading edge as they come under increasing pressure from investors to boost returns.

Generating alpha is becoming increasingly more difficult through the futures markets, as you have an influx of traders ... who are using similar trading strategies, says Amine Bouchentouf, President of Renaissance Investment Advisors, a New York-based financial advisory firm.

You can generate alpha at a substantially more attractive level (from physical assets) because the barrier of entry is high. The returns are more interesting than the futures market, he added.

But investing in physical assets is not an option for all.

Sheer financial capability will make it a significant barrier for many of the smaller hedge funds, used only to handling tens of millions of dollars and running operations with barely a dozen employees.

It's only an option for bigger funds, said one hedge fund manager, adding that hedge funds would need at least $300-$400 million to diversify into the physical world.

Investors in hedge funds must also be prepared to agree to minimum lock-in periods of up to five years in case of investments in physical assets, against a conventional time horizon of three months.

NOT WITHOUT RISKS

Industry insiders warn that investing in physical assets is no walkover. Hedge funds may be good in the virtual world of financial instruments, but the real world of physical assets can be tough, sometimes messy.

As a physical trader you need resources to handle the actual stuff, which is not an easy game, said the hedge fund manager, who asked not to be named.

It's risky. When you are dealing with physical commodities, you introduce a whole new layer of risk -- deliverability risk, volume risk...there is a whole new raft of risks that have to be measured and acted upon and hedged, said Vasey at UtiliPoint.

If you are interested in making real money, you are interested in illiquidity...that's an additional risk, but it's also an additional chance to profit.

Energy Investment