When Peter J. Creedon evaluates hedge funds, he looks for managers who have good track records that exceed their benchmarks by 25 percent.

“I use them for my clients who are accredited investors willing to take greater risk to gain a higher rate of return,” says Creedon, a financial advisor with Crystal Brook Advisors in New York.

First, Creedon evaluates a hedge fund's speciality and considers whether the fund invests domestically or internationally. He also assesses how to rebalance a client's portfolio if he's going to add the fund to the mix. “If I am trying to take more risk for greater return by investing in a hedge fund, I need to know in advance where I can balance off that risk in another part of the portfolio,” he told Financial Advisor.

It's tempting to dismiss the potential value that hedge funds can bring to a portfolio, but Creedon is among the advisors who are digging deeper to find hedge funds that are outperforming. “It’s about cost versus risk versus return when I’m choosing hedge funds,” he said.

Financial advisors cite diversification and alpha as two important reasons to add hedge funds to a client’s portfolio.

“Hedge funds can provide exposures you don’t already own in your cash, stocks and bond portfolio, which can improve both diversification and return,” says Katie Nixon, a financial advisor and chief investment officer at Northern Trust Wealth Management.

Even in the face of lackluster hedge-fund performance, Nixon believes hedge funds are worthwhile. “Most investors don’t have systematic risk-factor exposure in their portfolios, so any diversification benefit will have to come from a unique exposure not already in a conventional portfolio, like skill or certain risk premia,” Nixon said.

Advisor Cameron J. Penney prefers hedge funds that maintain low expenses but still achieve low correlated returns with the broader capital markets. “I find value in merger arbitrage and relative value hedge-fund strategies,” said Penney, with Penney Financial in Houston, Texas.

According to the study "Portfolio Efficiency with Performance Fees" by Windham Capital Management’s Mark Kritzman, the 2 and 20 model expenses burn up about 85 percent of hedge fund returns, which means a fund needs to consistently outperform to be worth the risk and cost.

As a result, due diligence is key. “We do a Finametrica survey to try and gauge the risk appetite of our risk-aggressive clients, then incorporate it into their investment policy statement,” says Steve Branton, a financial advisor in San Francisco.

Nixon also takes time to evaluate the niche managers of better-performing hedge funds. “We have a proprietary nine-factor model that teases out the true skill of hedge fund managers from luck and other conventional factors,” Nixon said.

Creedon reads the offering letter of a hedge fund first and then asks to see the manager’s trades. “I like to see where they are trading to make sure it’s real, but it’s easier to access that information from smaller hedge funds than the larger ones,” Creedon said.