While the rest of Wall Street is spinning off money management or figuring out a way to eliminate the perceived conflict of interest inherent in proprietary funds, Morgan Stanley is rolling out more homegrown products. However, instead of mutual funds or money market funds, the firm is pedaling funds of hedge funds.

Morgan Stanley’s latest offering, the advisor-sold Absolute Return Fund, targets accredited individual investors and small institutional clients seeking returns with lower volatility and lower correlation to equities. The holdings that comprise the portfolio include hedge funds run by Carl Icahn, D.E. Shaw & Co. and Oak Hill Partners. The move is part of the firm’s aggressive push in alternative investments, which became a stand-alone unit within Morgan Stanley Investment Management (MSIM) in December 2005.

Morgan’s move into hedge funds is an attempt to play catch-up with its wirehouse rivals. When its bid to acquire institutional money manager BlackRock (with $27 billion in alternatives assets) fell apart, the company needed to act swiftly to keep pace with its competitors Merrill Lynch, the successful acquirer of BlackRock, and UBS, the largest seller of hedge fund products.

[Meanwhile, the SEC announced today two new regulatory provisions governing funds of funds. One requires a registered fund that invests any of its assets in another fund, including an unregistered investment vehicle, to disclose in its fee table the cumulative amount of expenses charged by the fund and any fund in which it invests. Currently, fee tables don’t include fees and expenses charged by the funds in which the fund of funds invests. The other provision codifies existing exemptions that allow for greater flexibility for these vehicles, including allowing “cash sweep arrangements,” under which a stock or bond fund may invest its available cash in a money market fund.]

Under the leadership of newly appointed head of alternative investments Stuart Bohart, formerly the head of prime brokerage at Morgan Stanley and a portfolio manager since 1997, the New York-based wirehouse has rolled out six new alternative products, hired experienced managers and inked selling agreements with pension plans around the world.

In addition to its organic growth in hedge funds and private equity, Morgan Stanley is also looking to purchase money managers. “We are actively pursuing team liftouts and bolt-on acquisitions to bolster our efforts,” David Sidwell, Morgan Stanley’s chief financial officer, told attendees at a UBS conference in mid-May. At present, alternatives account for $18 billion in assets under the MSIM umbrella.

Without question, hedge funds and funds of funds have come downstream to the retail market, lowering minimums and registering with the SEC in the process (even before hedge funds were required to file as an investment advisor earlier this year). While investors still must meet the net-worth requirement, with minimums as low as $25,000, more accredited retail clients can invest. Used to diversify a portfolio, this is a good thing.

“There is a strong need to insert alternatives into their clients’ portfolios,” says David Prokupek, CEO and CIO of Denver-based boutique money manager Geronimo Financial. (Geronimo recently launched three of its own absolute return funds in January.) “You’re going to see advisors recognize that their clients want absolute return as part of their core portfolio strategy.” Geronimo, founded in 2002, has $400 million in assets and is distributed through Schwab, Fidelity, Fiserv, as well as other national RIA platforms.

Scores of academic research have shown that hedge-like strategies should be an integral part of the asset-allocation discussion, just like equities and bonds or growth and value. In turn, that has spurred a movement toward educating advisors and their clients on the benefits of absolute return strategies. The education process, coupled with the stinging pain from the bear market, has advisors looking to snap them up, Prokupek says.

But research published on Tuesday by Merrill Lynch suggests that investors may have cooled to hedge funds in the last year, with fewer products being brought to market and returns down significantly. According to Merrill’s World Wealth Report, average hedge fund returns have declined from 19.7 percent in 2003 to 7.1 percent in 2005. Hedge funds also recorded their first single-quarter net outflow in more than a decade during the fourth quarter of 2005, the study shows.

The reason for their waning popularity of late are a result of higher management fees to offset lower returns and more stringent government regulation. Having laid dormant for several years, private equity re-emerged as a popular alternative investment in 2004 after getting whacked during the tech wreck, and continued to attract high-net-worth investors in 2005, Merrill says. While interest in hedge funds may have dropped off somewhat, it is hardly cause for panic. The major wirehouse firms are heavily invested in alternatives, and advisors are still clamoring for hedge-like strategies like long-short and market-neutral.