Jan. 31 (Bloomberg) -- Hedge funds trading electricity in Europe may struggle to achieve targeted returns of 20 percent this year as markets become more connected and prices more volatile, Energy Hedge Fund Center LLC founder Gary Vasey said.

Such funds mainly invest in the Nordic market, where hydropower reserves traditionally have been the dominant price setter. The market is now increasingly influenced by German prices, fuel costs and carbon emission permits, said Vasey, co- founder of the center that tracks about 600 energy hedge funds and advises funds, energy companies and banks.

``Some of the historical trends are probably beginning to break down,'' Vasey said in a telephone interview from Prague. Power funds ``had a tougher year'' in 2007 than before, he said.

Funds trading electricity have attracted investors looking for diversification away from stocks, bonds and currencies as there is little correlation with traditional investments. Power and utility funds make up about 7 percent of the $55 billion managed by commodity hedge funds, according to a November estimate by Chicago-based investor Cole Partners Asset Management LLC.

Managers at Alfakraft AB, Nordic Commodity Funds AB and Norden Absolute Energy Management ASA all target annual returns of 15 percent to 25 percent, while Shepherd Energy aims for 15 percent to 20 percent, according to company Web sites.

Returns for 2007 at 10 funds investing some of their capital in electricity markets were varied. Alfa Energy Fund had a 37.5 percent gain. Nordic Power Fund had a loss of 1.1 percent since it started trading in April.

Volatile Coal Price

Hedge funds globally returned 10.4 percent on average last year, according to Chicago-based Hedge Fund Research Inc.

``We had a good result up until the end of the year when commodities went bananas,'' said Bengt Lindblad, managing director of Alfakraft, the manager of the Alfa Energy Fund.

European coal prices, a component of wholesale electricity pricing, soared 18 percent in the fourth quarter, buoyed by rising Asian demand, Australian bottlenecks and reduced Chinese exports.

``This year has started very volatile and will probably remain so until at least the summer, so we're adjusting our positions to that,'' Lindblad said in a phone interview from Stockholm. The Alfa Energy Fund returned 72 percent in 2004, 28 percent the following year and then a loss of 22 percent in 2006.

In the second half of 2007, 10-day volatility for the UBS Bloomberg Constant Maturity Commodity Index, made up of 26 different contracts, was as low as 3.8 percent and as high as 24 percent. Volatility is a gauge of price swings over that period expressed in annual percent. In the year earlier period, the range was narrower: between 6.9 percent and 20 percent.

First Power Fund

The Nordic region was the first power market in Europe to attract speculative investors. Interkraft ASA opened the world's first electricity hedge fund in 2001, managed from Oslo. The Interkraft Energy Fund returned 64 percent in 2002, it's first full year of trading.

More than half of the electricity in the Nordic countries is generated by running water through turbines. Last year was characterized by ``a strong hydrological situation,'' Fortum Oyj, Finland's biggest utility, said today in an annual earnings statement.

Carbon dioxide emission permits for Dec. 2008 last year traded as high as 25.15 euros ($37.29) a metric ton on London's European Climate Exchange last and as low as 12.25 euros. They closed at 22.41 euros on Dec. 31.

Schizophrenic Market

``High water levels provided a bearish undertone for the market at the same time as carbon emissions pushed up prices making the main drivers a bit schizophrenic,'' said Daniel Dahlin, chief investment officer at Stockholm-based Electris Asset Management Ltd. The Electris Energy Fund returned 6.45 percent last year.

The number of funds with more than a quarter of their capital in European energy jumped by 20 percent to about 60 funds last year, Vasey said.

Energy Capital Management BV spreads its risks and trading across more energy markets than other funds, in an effort to avoid declining returns, Chief Executive Officer Marcel Melis said.

``Our main exposure is in German power, U.K. natural gas and carbon, while most other funds have their main exposure in the Nordic power market and don't trade U.K. gas,'' Melis said in an interview from Amsterdam.

The company's MMT Energy Fund is targeting a return between 25 percent and 30 percent this year, he said. The fund returned more than 10 percent last year, according to investors. Melis declined to confirm the number.

Diversification

The fund trades Nordic power, oil contracts, financial coal, Dutch gas and power and Belgian power and plans to add French and U.K. electricity this year.

Peter Brewer, fund manager for the Cumulus Weather Fund didn't respond to e-mail and phone calls seeking confirmation on returns.

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets and participate substantially in profits from money invested.

The 2007 returns for the funds listed in the table shown below are from company web sites, obtained from investors or are available on Bloomberg. Figures in parenthesis are for 2006.

FUND NAME                          2007 Returns

Alfa Energy Fund                   +37.5% (-21.7%)
Norden Absolute Energy             +12.4% Since February
Cumulus Weather Fund               +10.6%
MMT Energy Fund                    Above +10%
Electris Energy Fund               +6.45% (June-Dec '06 3.59%)
European Energy Fund               +5.54%
Interkraft Energy Fund             +4.23% (18.7%)
Shepherd Energy Fund               +3.0%  (+8.4%)
Markedskraft's Elexir Fund         -0.1 % (34.4%)
Nordic Power Fund                  -1.11% Since April

To contact the reporter on this story: Lars Paulsson in London at lpaulsson@bloomberg.net

Last Updated: January 31, 2008 12:11 EST