When hedge funds were introduced in the 1940s (the first by a former journalist, by the way), the idea was to hedge, as in to protect. As we learned recently, the credit crisis devastated many hedge funds too. Faced with sizable losses, 2,400 funds liquidated in 2008 and 2009, according to Hedge Fund Research. That was a huge decline for a business that had 10,000 funds at the height of the market.

But these days the hedge fund industry is getting back on its feet. During the first five months of 2010, hedge funds recorded $26.5 billion in net inflows, according to HedgeFund.net. Assets in hedge funds total $1.7 trillion, up from a low of $1.4 trillion in 2008, according to Hedge Fund Research. Much of the new money has been coming from sophisticated pensions and sovereign wealth funds.

The smart money is returning because investors are seeking vehicles that can excel in downturns and can help to diversify portfolios. Hedge funds can provide downside protection, because they sell short and use other techniques that can produce profits when most stocks are falling.

Right for Your Clients?

Should you steer high-net-worth clients to hedge funds? Perhaps. For all the turmoil of recent years, hedge funds have been performing as might be expected, outdoing stocks in downturns and trailing in up markets. In 2008, the hedge funds tracked by Morningstar lost 22 percent, outpacing domestic equity stock funds, which lost 36.1 percent. While short-selling helped in the downturn, it held back hedge funds when the markets revived. In 2009, hedge funds returned 20 percent, compared to 31 percent for domestic equity funds.

Because they limit losses in downturns (depending on the strategy, of course), hedge funds have produced appealing results in recent years, says Peter Laurelli, vice president of Channel Capital Group, a hedge fund tracker. During the nine years ending in 2009, hedge funds returned about 8 percent annually, while domestic equity mutual funds produced negative returns. Laurelli cautions that typical hedge fund investors may not have done as well as the average figures suggest. A small number of top-performing portfolios skewed the results. In addition, some disastrous funds stopped sending their returns to databases, a process that boosts overall average results. Still, plenty of hedge fund investors got annual returns in excess of 4 percent, a decent showing in a difficult decade.

Make no mistake, hedge funds come with plenty of risks. Many portfolio managers leverage heavily. That can boost returns in bull markets — and create disastrous losses in downturns. For a steadier approach, consider a fund of hedge funds. Those invest in groups of 20 or so hedge funds. That way the portfolio can still produce decent results if one or two funds blow up.

Funds of funds require steep initial minimum investments that typically start at $250,000. Those with smaller wallets may want to try a new kind of mutual fund that aims to track the broad universe of hedge funds. Initial minimum investments are as low as $1,000. The mutual funds are young, but they have demonstrated an ability to limit losses in downturns.

The new funds represent an intriguing breakthrough. For years, fund companies have attempted to design portfolios that would track an index of hedge funds. Developing a passive fund proved difficult because of the nature of the hedge fund universe. To build an index fund that tracks the S&P 500, you simply buy the 500 stocks. But it is not possible to invest in all hedge funds, because many of them are closed to new investors or charge huge initial minimums.

The new mutual funds use different techniques to deliver the volatility and results of the hedge fund markets. One of the newcomers is Goldman Sachs Absolute Return Tracker (GARTX). During the fourth quarter of 2008, the fund lost 7.0 percent, outdoing the S&P 500 by 14 percentage points. In the difficult first quarter of 2009, the fund surpassed the benchmark by 8 percentage points.

To achieve the results, Goldman studies a group of 4,000 hedge funds. Then the portfolio managers use futures and other securities to replicate the characteristics of the universe. “We want to offer an investment that has relatively low volatility and little correlation with stocks or bonds,” says Glen Casey, managing director at Goldman Sachs Asset Management.

Like traditional index funds, Goldman Sachs Absolute Return will always deliver middling results and lag well behind star managers. But the mutual fund does have some noteworthy advantages, including lower fees. While Goldman charges an expense ratio of 1.6 percent, typical hedge funds impose annual management fees of 2 percent plus performance fees that are 20 percent of profits. In addition, the mutual fund enables investors to withdraw their money every day. In contrast, traditional hedge funds lock in investors for periods of three months or longer.

Another fund that has shined in downturns is IQ Alpha Hedge Strategy (IQHOX), which returned 1 percent during the difficult fourth quarter of 2008. The fund replicates hedge funds by holding a portfolio of about 20 exchange-traded funds, including long and short positions, in stocks, bonds, currencies, and commodities. “ETFs are simple to understand, and there are enough on the market to cover all the major asset classes,” says Adam Patti, chief executive officer of IndexIQ, the fund's manager.

The biggest holding in the fund recently was cash, which accounted for about 40 percent of assets. ETFs in the portfolio included iShares MSCI Emerging Markets Index (EEM), PowerShares DB G10 Currency Harvest (DBV), and Vanguard Short-Term Bond (BSV).

ASG Global Alternatives Fund (GAFAX) uses futures to replicate hedge funds. While the portfolio managers roughly track the universe, they sometimes depart from the benchmark to limit losses. If the market starts falling sharply, the fund will automatically lower its risk level to protect assets. The aim is to maintain a steady volatility level, as indicated by standard deviation, a measure of how much a portfolio bounces up and down. The fund seeks to have an average annual standard deviation of 8, less than half the level of the S&P 500. “We promise shareholders to maintain a pretty steady level of volatility, and we have done that so far,” says Andrew Lo, a portfolio manager who is a professor of finance at the Massachusetts Institute of Technology.