Many advisors still aren't convinced they are the way to go

In the absence of any signs of a rebound in the stock market, advisors continue their search for alternatives to bonds, stocks and long-only mutual funds. Yet after three consecutive years of equity market losses, many advisors remain wary of the most hyped of these alternatives vehicles: hedge funds.

"There is a gimmick factor I'm worried about," says A. Todd Black, president of Dogwood Capital Management in Cumming, Ga. "Everybody wants to be perceived as being proactive and looking at other alternatives. In reality, we're trying to find a short-term fix."

Black says he is keeping an open mind about hedge funds and started investigating them for possible use in his firm four years ago. But he still doesn't like what he sees in the hedge fund market, even with the growing popularity of "funds of hedge funds" products that have been touted as a more palatable gateway into the market.

Among his chief concerns are the veil of secrecy under which hedge funds continue to operate and their relatively high expense ratios. Black feels there are reputable hedge funds out there, but he says it takes expertise and time-consuming due diligence to find them or, at the very least, understand how they invest.

"When it comes right down to it, I am in the people business and my energy is better used focusing on my clients," he says. "This is not a strategy that should be employed by inexperienced or unsophisticated investors, regardless of whether or not they are qualified."

Not that hedge funds haven't been making inroads in the advisor market and in the investment universe in general. Global hedge fund investments climbed to about $650 billion last year, up from about $480 billion in 1999, according to Van Hedge Fund Advisors International, a global hedge fund advisory firm. During that same time frame, the number of global hedge funds has grown from 6,200 to 7,500. Standard & Poor's has also announced plans to come out with a hedge fund index of its own.

Feeding the growth has been the expectation that these historically niche products can add market neutrality and stability to portfolios that have been eroded by a bear market in recent years. Hedge fund indexes certainly encourage that view. Since the start of the bear market in early 2000, the Van U.S. Hedge Fund Index has increased 2.6%, while the S&P 500 has dropped about 44%. The Hennessee Hedge Fund Index, meanwhile, was down 3.43% last year-its first negative year since it was created in 1987.

Some advisors have seen this type of performance reflected in their own portfolios. Andy Berg, a partner with Homrich & Berg, financial advisors in Atlanta, says his firm began work to build its own fund of hedge funds portfolio at the height of the bull market in 1999.

"We wanted to look for other ways to skin the cat, because we thought the market was materially overvalued," Berg says. "We wanted other ways to achieve an attractive return outside a long-only stock position."

Building its hedge fund portfolio with funds using market-neutral, long-short strategies, the firm has averaged about a 12% gain per year since it was started, he says. The fund of funds represents between 15% and 20% of most of the firm's clients, he adds.

Similarly, Wescap Management Group in Glendale, Calif., started its own hedge fund of funds 11 years ago. "When the fund was started, there was simply no other practical way to participate in the many hedged strategies," says Mark Gleason, senior financial advisor at the firm.

While the Wescap fund lost 3% in 2002, it has achieved average annual gains of 11% since creation and a cumulative return of 15% over the past three years, he says. The due diligence involved in such an undertaking includes visiting with hedge fund managers, checking on custodial records and background checks on fund principals, he says. "It is time intensive," Gleason says. "You've got to see if they're doing what they say they are doing."

The need for such scrutiny and the lack of transparency when it comes to how hedge funds operate are, however, among the reasons many advisors have decided seek investment alternatives in other ways. Tom Davison, senior financial advisor with Summit Financial Strategies in Columbus, Ohio, opts to use a mix of the arbitrage-strategy Merger Fund, REITs and international bond funds unhedged to the U.S. dollar as market diversifiers. He has had his eye on several fund of hedge fund products, including those offered by Undiscovered Managers, J.P. Morgan and Ascendant, but is holding off until they build up a track record-while noticing a drop-off in the number of new fund of funds products.

"Last year we'd get a call a week from someone that was launching a new product," he says. "Those calls have dried up recently."

Among the reasons he steers clients away from hedge funds is the lack of hard information that is available for due diligence. He cited one client who independently invested in one successful hedge fund, but was unable to confirm the prices of its investments in its audited financials. The report noted that all prices could not be verified because they were independently provided by the fund manager-a common practice with hedge funds. "We call the hedge fund and ask what percentage of the financials are priced this way, and get the run-around," Davison says.

Another practice that dissuades him from hedge funds is managers closing down funds and starting new ones when they feel performance is too far out of reach of high-watermark performance fees.

These concerns, he says, are not completely resolved with the fund of funds approach because even these vehicles provide only limited transparency. "What the fund of funds people's message comes down to is, 'Trust me,'" Davison says.

Hedge funds can work as a market diversifier-if you find the right ones, says Gary Greenbaum, partner in Greenbaum and Orecchio, wealth managers in Old Tappan, N.J. That job has been made easier by the fact that the hedge fund market is no longer dominated by macro strategies that "can turn on a dime" without investors knowing about it. Five years ago, such funds made up 70% to 80% of the market, compared with about 10% to 15% today.

Greenbaum says his firm concentrates on index and arbitrage hedge funds-ones that are more dependent on style than an individual manager for positive results. "We're not part of the alpha-chasing crowd," he says.

At FirstTrust in Daytona Beach, Fla., investment managers integrate hedging techniques into its investment strategy rather than relying on hedge funds, says Chris Cannon, director of the firm's investment division. "The net effect is we haven't had nearly the downside in the overall portfolios that we would have had we maintained our kind of old, limited choices," he says.

The typical fees of a hedge fund-usually structures where the manager takes a fee of 1% of assets and 20% of profits-and the lack of regulation and transparency are the main reasons the firm stays away from hedge funds, he says. With fund of fund products, he maintains, those issues remain and are compounded by an additional layer of management and its associated fees, he adds. "You're taking two leaps of faith," he says. "The first is in the actual investment in whatever fund. The second is to trust whoever the person is picking these hedge funds."

Some advisors have found adequate diversification through the use of mutual funds that use hedge strategies, such as the Merger, Arbitrage and Gateway funds, Calamos Market Neutral, Caldwell and Orkin Market Opportunities, and Leuthold Core Investment funds.

Richard Schultz, president of Schultz Financial Management in Santa Ana, Calif., went on a search for alternatives after the stock market went south in 2000.

Dissuaded from using hedge funds because of high minimum investment requirements and high fees, he started to put clients into the Calamos Market Neutral Fund, which uses an arbitrage strategy of holding convertible bonds and shorting their underlying stock. "It was market neutral and it was hedged," he says. "It's actually expected to do a little better in a down market than even a sideways market because of the short plays on the stock."

The fund, which is now closed to new investors, brought returns of 10.3% in 2000, 8.3% in 2001 and 6.6% in 2002.

At Legend Financial Advisors in Pittsburgh, such mutual funds, as well as fund of hedge funds products, such as one offered by Undiscovered Managers, are used as the building blocks for low-volatility portfolios, says firm President and CEO Lou Stanasolovich. "They are designed to provide equity returns of 8% to 12% with minimum volatility," he says. "They're not going to follow the market upward, and they're not going to have wide swings."