Back in 1998, Larry Bell wouldn't have dreamed of investing his clients' money in hedge funds. After all, just that year, Long-Term Capital Management had imploded spectacularly, threatening the U.S. financial system. As a result, Bell, and just about everyone else for that matter, came to regard the asset class as nothing more than tomfoolery — opaque financial vehicles amped up on leverage with a license to take imprudent risk. Anyway, in those days, who needed hedge funds when you could get double-digit returns by cobbling together a portfolio of large-cap tech stocks? “Why bother with hedge funds?” Bell, a financial advisor at Summit Financial Resources, from Parsipanny, N.J., recalls thinking. “We were making so much money selling no-load S&P Index funds.”

That line of thinking expired with the bull market. Hedge funds and other alternative investment vehicles are now seen as the way to make money, given the uncertain outlook for stocks and bonds. Besides, “I just don't know why taking all your money and going long the S&P 500 is considered so conservative,” says David Saunders, a principal in K2 Advisors, a New York boutique that creates funds of funds for institutions and wealthy individuals. “The fact is, a well-constructed fund of funds is less risky than a group of long-only managers.” Michael Steinhardt, the famous hedge fund manager puts it this way: “Hedge funds are nothing but a speculative means toward a conservative end.”

Bell gave his clients who qualify (see sidebar on page 39) exposure to hedge funds, and kept most of them out of negative territory last year. Consequently, Bell retained 95 percent of his business. He is not alone. Last year, hedge funds pulled in record amounts, grossing $86 billion, up from $8 billion in 2000.

That figure includes money from institutions, but brokers have been tiptoeing into the hedge fund business because their firms are starting to offer such products. And there are more reasons to seek these alternative investments: If you believe in mean reversion, the equity markets are not going to be as robust as they were in the '90s for a long time. Investing for absolute returns, then, will please clients. And, as one rep put it, “If I don't know about hedge funds and I can't offer them, my competition will.”

He got religion on the subject when a high-net-worth client showed him a DLJ fund of funds offering memorandum and asked him to analyze it. “I about died when I saw that my client had to open up a DLJ brokerage account to invest in that fund,” he says. “Then I thought, first DLJ's going after his alternative asset money — next, they'll try to take the rest.”

Therefore, the case for hedge-fund investing grows stronger. And the case against? Critics carp that funds of funds, the vehicle used by most retail brokers, charge too much in fees, operate too secretly and don't offer the sexy returns they advertise. Last year, for example, according to one survey, the 800 or so hedge funds that deigned to report, returned about 4 percent — what a riskless T-bill did. To boot, the sheer number of strategies available has become staggering, making them difficult to choose and harder to monitor.

Misunderstood

But critics may overstate their case. Hedge funds were originally conceived to do just what the name implies, hedge. With the outlook for the capital markets decidedly murky, more and more advisors are discovering that hedge funds can achieve absolute returns that are not tied to the direction of either the equity or credit markets. Some fund strategies, for example, posted double-digit returns last year. Overall, the funds outpaced the S&P's drop of 12 percent.

In fact, when properly used, hedge funds do in fact add return and lower risk. For example, in the five years ending last September, a typical long-only stock portfolio returned an average 5.2 percent with an average annual standard deviation of around 19 percent. But if you mix in a 25 percent exposure to the Altvest long/short indices, the return jumps to 9.8 percent a year and the standard deviation actually fell to 16 percent, according to Altvest.

Unfortunately, most hedge funds are limited to so-called accredited investors, defined by the SEC as people who make more than $200,000 per year or have $1 million in investable assets. Under this definition, no more than 100 people are allowed to invest in a fund. Then, in 1996, the SEC created a new investment class that increased the number of investors in such funds to 499 and the investable assets minimum to $5 million.

The most recent innovation: Some hedge funds are registering with the SEC, which allows them an unlimited number of investors. As a result, hedge fund managers can lower the minimum dollar investment, some as low as $25,000. That makes investing in such funds all the more attractive. After all, not every accredited investor would want to pony up the $500,000 or more minimums before managers began filing with the SEC.

The best vehicle for most brokers is the fund of funds, which is a fund that invests in other hedge funds. The investor rules remain the same, but a broker doesn't have to pick out of the 6,000 individual funds for the best. To bring some hedge fund-like protection to the portfolios of smaller investors, brokers can also use hedge-fund-like mutual funds (see page 51).

Not surprisingly, regional brokerage firms and wirehouses alike are jumping into the game, creating a lineup of funds of funds. They are enticed by the juicy fees. Fund of fund managers also collect a management fee (around 1.5 percent) and, typically, around 10 percent of any profits.

Morgan Stanley, Merrill Lynch, and UBS PaineWebber either have launched or are getting ready to launch their own hedge funds. “I don't know a reasonable size brokerage house that isn't thinking of a fund of funds,” says Christopher Acito, a hedge fund specialist for BARRA Research Consulting Group. Most of the funds of funds are diversified among different managers (often 10 or more), who invest in different asset classes, sectors, geography and styles. “The goal is to achieve returns by security selection and not by market direction by diversifying over a bunch of different types of managers,” says Saunders.

The firms have done the homework, choosing and creating conservative funds of funds in which the underlying managers are prohibited from using anything but a small amount of leverage. Better still, a fund of funds manager acts as your personal expert, sifting through the available managers and selecting ones he or she believes can perform most consistently. The über-manager also then makes sure the manager sticks to his style.

“I realized that hedge funds were not our specialty, so I had to find someone for whom it was,” says Carl Zuckerberg, managing director of the Connecticut-based financial advisor firm, Relyea, Zuckerberg, Hanson. He spent two years researching hedge funds before settling on a fund of funds. Zuckerberg uses a fund of funds that gives his clients exposure to 15 underlying managers for a small minimum investment of $50,000.

While a typical manager will probably not disclose the ins and outs of each trade, he will usually provide a sketch of his overall strategies in the offering memorandum (something like a prospectus for IPOs). Certain funds can be safe with less volatility than the Lehman Government Credit Bond Index. For instance, Tremont Advisers offers the American Masters Market Neutral Fund, which uses various arbitrage strategies to maintain neutral beta and neutral dollar position. The fund sports a standard deviation of just 2.1 percent, but only aims to a return a little above that of a two-year Treasury note. By contrast, the American Masters Multi-Tech Fund puts long and short positions on anything from biotech to wireless and produced an impressive 6.4 percent gain in 2001. However, its standard deviation was 14.5 percent, making it more volatile.

Make sure your fund managers stick to their purported strategies. Rob Isbitts, of Emerald Asset Financial Advisors, does this by doggedly watching his funds' hurdle rates (or target returns). “One of my fund of funds' goals is 9 percent to 12 percent,” he says, “That tells me that in a speculative market environment, they won't get greedy and try to make 50 percent.” He recently passed on one fund of funds that simply aims for “high returns.”

Also, beware of managers who take on too much leverage. Anyone can be seduced by leverage, which intensifies the pleasure of rising returns. Trouble is, it also magnifies losses in the same way.

Richard Hellberg, a financial advisor from Peter Alexander Financial outside Philadelphia, combs through each fund of funds offering memo to find what specific limitations on leverage are listed. Sometimes he's shocked by what he reads. “I had one come across my desk that said ‘Leverage could go anywhere from 0 percent to 100 percent,” says Hellberg. “That means he could go from no leverage to borrowing as much as he wanted. No thank you.”

Another rule to remember: A big hedge fund rarely makes for big returns (see page 75). Just like in the mutual fund industry, a fund of funds that grows assets too quickly often winds up making bad investment decisions as it tries to put all its cash to use.

Also, make a practice of interviewing your manager frequently. Zuckerberg frequently calls up each of his funds of funds to ask specific questions about their activities. After OppenheimerFunds purchased the Tremont funds, Zuckerberg began peppering Tremont's sales manager with questions. “I said, ‘Oppenheimer is great at marketing products. How are you planning to control the tremendous inflow of assets that could come from strong marketing?’” says Zuckerberg.

If your managers aren't willing to answer your questions, take your money elsewhere. “Don't be impressed by someone who is giving you a pitch and says they won't go out of their way to explain things to you,” warns Acito of BARRA. “You can't give money to people who aren't willing to tell you what they're doing with it.”

A fund of funds manager will probably cost your client a small fortune in fees. Typically, a fund of funds manager charges 1.5 percent management fee, and underlying managers charge a 1 percent management fee. On top of those costs, clients also pay what's known as an incentive fee, around 20 percent of profits, assuming the hedge fund manager can meet or exceed his hurdle rate (if he has one). And, some fund of funds managers charge yet another 10 percent incentive fee of their own on any profits from the underlying managers. By the way, all these fees are before your own wrap fee (see the fee workbook on page 37). Imagine the angry phone call you would receive if you never properly explained this to your client.

“I tell my clients to look at everything on a net return basis,” explains Richard Staves, financial advisor at Cambridge Financial Services. “Ask yourself, ‘How much do I put in my pocket?’ If you made 6 percent or 7 percent after fees, that's better than losing money.”

Of course, if you work for a major wirehouse like Merrill or Smith Barney, selecting a fund is not your problem. Chances are you can only sell products that the firm runs itself. Luckily, more major brokers than ever are launching their own hedge funds — and not just for super high-net-worth clients. PaineWebber recently launched two fund of funds for a $100,000 minimum. “We figure what's good for the institution, must also be good for the individual investor,” says PaineWebber's head of alternative investing Mitchell Tanzman. “You don't have to be a billionaire to get into this fund.” Brokers at OppenheimerFunds can now offer Tremont funds of funds, and Mellon Asset Management recently purchased 15 percent of Optima hedge funds. And Merrill offers hedge funds to its clients.

Others plan to embrace a more open-ended product line, where clients can choose from a buffet of externally managed funds. Though no one at the firm would confirm it, Prudential Securities has reportedly set up agreements with Torrey Funds, a top-performing fund of funds. And Charles Schwab is toying with a similar strategy. Many major regional firms have been quicker to sell a range of products. For instance, Wachovia Securities, McDonald Investments and Lockwood Financial all offer some Tremont funds to their clients. The open architecture structure makes more sense, mainly because it allows clients to get access to the most successful products out there — and not just the manager owned by the firm. What's more, when a manager fails to perform, the brokerage firm can quickly change to another fund, whereas companies offering in-house hedge fund managers tend to stick with its own funds. “I would say firms like Prudential are very well positioned for hedge funds,” observes Acito.

Some managers say the democratization of the hedge fund will bring vast improvements to the industry. For one thing, the veil of secrecy will eventually fade away. One of the conditions under which hedge funds can accept more investors is that they file with the SEC, thus providing investors with a quasi-10-K's worth of information. Log onto Edgar, and you'll find filings on Montgomery, Morgan Stanley and Tremont. Also, hedge funds are expected to win the right to market their products within the next few years. Presently, they may not advertise their funds.

Yet, some advisors worry that more hedge fund investors will mean more problems. Bell, of Summit Financial Resources, says, “What if the hedge fund companies can't handle the growth?” Even more problematic, hedge funds could suffer from the same bubble effect that plagued technology stocks, where assets grow larger and larger and then collapse at the first sign of trouble.

At the end of the day, a good hedge fund manager is trained to avoid such speculative disaster. Your job is to figure out who which managers will do that.

Fee Workbook: You Get What You Pay For

Sure, a good fund of funds can produce strong returns with limited volatility, but the fees can get mighty steep. Below, we've created a fund of funds that took $100,000 and produced a net profit of 20%, bringing annual total returns to more than $121,550.

Here's what your client took home, approximately, after fees:

Without Fee: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Assets Under Management $100,000.00 $105,000.00 $110,250.00 $115,762.50
Profit of 20% $5,000.00 $5,250.00 $5,512.50 $5,788.13
Total Return $105,000.00 $110,250.00 $115,762.50 $121,550.63
With Fees: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Assets Under Management $100,000.00 $104,206.88 $108,590.73 $113,159.00
Annual Profit of 20% $5,000.00 $5,210.34 $5,429.54 $5,657.95
Total Return Before Fees $105,000.00 $109,417.22 $114,020.26 $118,816.95
Underlying Management
Fee of 1%
$262.50 $273.54 $285.05 $297.04
Underlying Incentive
Fee of 20%*
$136.88 $142.64 $148.64 $154.88
Total Returns After
Underlying Fees
$104,600.63 $109,001.04 $113,586.58 $118,365.03
Fund of Fund Management
Fee of 1.5%
$393.75 $410.31 $427.58 $445.56
Total Returns After All Fees $104,206.88 $108,590.73 $113,159.00 $117,919.46
Total Annual Fees Charged $3,631.16
* The incentive fee, or carry, is charged only when the hedge fund beats its hurdle rate (often around 8%), and exceeds the high-watermark (the peak performance in the previous years).
To calculate the fee, this manager subtracted Total Return After Management Fees from Total Returns on 8%, then multiplied the difference by 20% for the year.

Who Qualifies?

Hedge funds may be more accessible than ever, but that doesn't mean anyone can get in. The SEC still requires investors to fulfill certain criteria before purchasing alternative investments, such as fund of funds. Make sure your client fits at least one of these definitions before even mentioning hedge funds.

Accredited Investor: Someone with over $1 million net worth, or an income over $200,000 for the last two years (if married, $300,000). These investors may invest in deals that are either limited to 100 investors ("Section 3-c-1" companies) or registered under the 1940 Investment Company Act (known as "registered funds").

Qualified Purchaser: Someone with at least $5 million in investments. These are the only clients eligible to invest in Section 3 (c) (7) companies, privately placed funds with no more than 499 individual investors.

Qualified Client: Someone with over $1.5 million net worth or $750,000 under the management of a single advisor. Many hedge funds prefer Qualified Clients to Accredited Investors.