It's no mystery why everybody and his brother — and sister — seems to be starting a hedge fund. After three years of double-digit losses in virtually every major equity index, there is massive demand for investing vehicles that have big bumpers, air bags and safety belts. So, the hedge fund business has doubled in four years, to an estimated 6,000-plus funds with $600 billion under management.

The growth has drawn scrutiny and criticism. With low barriers to entry and light regulation, hedge funds have been identified (repeatedly) as the next investment bomb, just ticking away as more and more ordinary investors pile in, a calamity waiting to happen. The critics point to last year's hedge fund performance, which fell well short of historical returns, as burgeoning proof of their point. (CSFB Tremont, which tracks the performance of about 2,000 hedge funds, says the average fund lost about 10 percent.) The number of funds liquidating is reaching an all-time high — an estimated 800 last year. And the SEC is cranking up its investigative machinery to see if hedge funds are on the level. William Donaldson, the new SEC chairman, is expected to issue new regulatory proposals in the spring.

So, why bother rooting around in that snake pit? Here's the reason: Hedge funds are not the daredevil investment vehicle that they're made out to be (see “Debunking the Myths that Dog Hedge Funds,” page 46). In fact, they might very well be an essential component of a bear market portfolio. Mario Gabelli, CEO of the $20 billion asset management firm that bears his name, told the Financial Times recently, “We may be coming back to the time when commodities and absolute return-type strategies will be the only strategies investors want.” Gabelli predicts the days of trying to beat the S&P 500 are over.

Even retirement accounts might need exposure to the asset class, says Avi Nachman, of market research from Strategic Insight. “The possibility of a lingering bear market for years to come may necessitate a fiduciary allocation to non-correlated asset classes.”

A.W. Jones, a former journalist, is credited with establishing the first hedge fund in 1949 as part of an effort to preserve wealth by “hedging” risk. The underlying concept is one of simple diversification. By using non-correlating assets, an advisor can dampen market volatility and improve returns. It's hardly a wacky concept. It's a plain example of modern portfolio theory, which every rep studies in basic training.

Rick Lake, chairman of Lake Partners, a Greenwich, Conn., hedge fund consultancy and creator of multi-fund portfolios, boils the hedge fund phenomenon down to its essence. They “offer the hope of consistent returns regardless of the direction the market,” he says.

There are about 10 broad categories of hedge-fund strategy, ranging from long/short equity to managed futures. Not all are conservative. Some, in fact, are the highly leveraged, high volatility speculative vehicles that give critics the heebie jeebies. To achieve absolute returns, a hedge fund manager can't track too closely to the direction of the capital markets. The “absolute return” industry — which might be a better way to describe these vehicles — has done a good job of preserving investors' wealth over the years. In fact, by using hedge funds, institutional investors, particularly universities and endowments and some pension plans, have preserved billions of dollars — despite market reversals.

According to a survey by the National Association of College and University Business Officers, college endowments suffered a mere 6 percent decline on average last year as a result of their diversification into alternative strategies. The group says that more than 5 percent of the investment dollars held by its survey participants are in alternative investments. Yale University, one of the most successful institutional investors over the last 20 years, has more than a quarter of its endowment in absolute return strategies.

Until recently, hedge funds were available only to institutions and to individuals who could afford to ante up the big minimum, typically around $250,000. But now a new breed of hedge funds, aimed at the so-called mass affluent, has emerged. These funds carry investments minimums of just $25,000. To offer these, asset managers register with the Commodities Futures Trading Commission (see related story, page 49) or with the SEC under the Investment Company Act of 1940. Both registrations allow fund of funds to accept an unlimited number of investors; this allows them to take small minimums. Non-registered funds are restricted to either 100 accredited investors (who earn $200,000 a year or have $1 million in assets) or 499 qualified investors ($5 million and up).

Everyone from Salomon Smith Barney to McDonald Financial is offering or is preparing to offer a line of registered funds of funds, their own or third-party funds. Europeans are moving in, too. Britain's Man Group, the largest hedge fund company in the world with over 200 hedge products and assets of $23 billion, is now gunning for the U.S. market. It opened offices in Chicago and has launched its first registered hedge fund of funds for U.S. investors.

But to invest in registered funds of funds, investors still need to be accredited (or qualified). And this shuts out most people. So, what can they do? Thanks to the repeal of the Short-Short Rule in 1997 (which severely limited mutual funds' ability to short), there are now about 40 or 50 mutual funds using some long/short strategy, says Lake. If you include mutual funds that go short on occasion or make use of other traditional hedging strategies, such as arbitrage, options, whatever, there are another 100 to 150 mutual funds with another $150 billion in assets out there, says Lake.

To take proper advantage of these, “reps will need to educate themselves and their clients as to risk-return characteristics and what the appropriate performance expectations should be,” says Lake.

Nachman, of Strategic Insight, says that asset management firms are now building wholesaling teams and will start to focus on financial planners “whose sound judgement and investment choices have already gained the trust of their high-net-worth investors.”

While industry experts agree that such strategies are necessary for reps who have high-net-worth business pretensions, keep in mind certain clients are not appropriate. First, tax-adverse clients should only own these in non-taxable accounts (these strategies typically require high turnover). Secondly, “Planners who attract and retain high velocity, hyped up clients — or clients likely to focus on fund of funds complexity — may be less effective as targets,” says Nachman.

Further, Nachman says that reps who are already successfully using fund of funds are “often those not obsessed with knowing all the nuances of hedge funds but rather are comfortable in getting the answer when needed.”

With an absolute return strategy as part of your asset allocation model, you can avoid some of the pitfalls of the relative return approach, namely index or peer-group hugging — and mediocrity.

Hedge Funds for Mr. Average

These mutual funds use hedging strategies. R-squared measures how closely a portfolio's performance correlates with the market. An R-squared of 1 means it is perfectly correlated; 0 means no correlation. R-squared figures through 01/31/2003; Return figures through 02/20/2003

Fund Name Ticker Family 3 Yr. R-square Expense Ratio 1 Yr. Return 3 Yr. Return Fund Net Assets
Boston Partners Long/Short Eq Inv BPLEX Boston Partners 0.005% 2.72 -0.47 26.02 45,530,000
Lindner Market Neutral Inv LDNBX Lindner 0.01 2.13 0.34 2.50 7,600,000
James Market Neutral JAMNX James Advantage 0.01 2.23 1.24 8.02 8,340,000
Fifth Third Strategic Inc Adv MXSFX Fountain Square 0.02 1.85 6.65 11.03 29,870,000
Gabelli Mathers MATRX Gabelli 0.07 1.35 -11.28 -1.32 79,250,000
Permanent Portfolio PRPFX Permanent Portfolio 0.09 1.46 14.28 7.83 55,250,000
Waddell & Reed Adv Asset Strategy A UNASX Waddell & Reed 0.13 1.42 2.28 3.77 371,070,000
ING Classic Principal Protection II B APPBXING Funds 0.14 2.25 3.69 1.89 87,380,000
Scudder Target 2011 KRFBX Scudder 0.14 0.96 3.93 2.32 112,610,000
W&R Asset Strat C WASCX Waddell & Reed 0.15 2.20 1.58 2.99 52,170,000
Scudder Retirement VII KRFGX Scudder 0.16 1.08 4.74 4.38 35,040,000
Franklin U.S. Long-Short FUSLX Franklin Templeton 0.17 2.10 -0.79 10.76 130,170,000