What to look at when deciding what choice is right for your clients.

Should you put your well-heeled clients into unregistered or registered hedge funds? Or is it better to select a mutual fund that uses hedge-fund tactics and is managed by a registered investment company?

With unregistered hedge funds, only accredited investors-individuals with a net worth of at least $1 million or an annual income of at least $200,000 for the last two years-are permitted to invest. The minimum initial investment in a hedge fund typically ranges from $1 million to $5 million.

Unregistered hedge funds are not subject to many of the strict rules that govern their mutual fund counterparts when it comes to, for example, the nature of their investments and how much they can borrow. Hedge funds that have registered under the Investment Company Act of 1940 are subject to the same rules and investment restrictions as mutual funds. They are structured as closed-end funds, but are only available to well-healed investors.

Unregistered hedge funds generally do not have a board of directors. Nor do they have a standardized format of presenting performance results. Hedge fund investors usually pay an asset management fee and a performance fee of 20% or more of a hedge fund's annual profits. If there are no profits, no fee is paid. It also is harder to get out of an unregistered hedge fund.

Two Web sites that list the performance of unregistered hedge funds include www.hedgefund.com and www.hedgefund.net. Advisors can get information on registered hedge funds at www.hedgefunds.net/access.

Regardless of whether they are hedge funds or mutual funds using hedge fund strategies, these investments are designed to deliver returns that are not correlated with the equity market.

Lower volatility hedge funds may use the following investment tactics: merger arbitrage, convertible arbitrage, distressed securities investments, capital structure arbitrage and long/short market neutral investments. Aggressive hedge funds might be highly leveraged, engage in only short sales, make market-timing moves, invest in distressed securities or use global macroeconomic trends to invest.

A handful of mutual funds use some of these investment tactics, within limits. Such mutual funds with at least a three-year track record, according to Morningstar Inc, include: AXA Rosenberg Market Neutral, Calamos Market Neutral, Phoenix Market Neutral and Boston Partners Long/Short Fund. These funds grew at an average 6% annual rate over the past three years ending in September 2003. By contrast, the S&P 500 lost 10% annually over the same period.

Although these mutual funds performed well, analysts say that if your clients can afford it they might be better off in hedge funds, which have more investment flexibility. Over the past three years, hedge-fund-like mutual funds performed in line with the average return on unregistered hedge funds, according to Morningstar and Hedgefund.net data. But the data is distorted. It compared only seven mutual funds against data on more than 1,000 hedge funds. So random chance is a significant factor in these results, says Deborah Lee, an analyst with Hedgefund.net.

Jim Graves, director of HFN/Access, N.Y., which tracks registered hedge funds and is affiliated with Hedgefund.net, says there are only a few registered private-equity hedge funds with longer-term track records. Currently, there are about 55 funds in registration. For his current year-to-date ending in September, the average return on registered funds is slightly below the 6% return on the average fund of funds hedge fund, adds Graves.

There are caveats when dealing with an unregistered hedge fund. The Securities and Exchange Commission has seen a dramatic rise in enforcement actions against hedge funds, and warns that this is despite its limited ability to take action against these investments.

In fact, the SEC staff recommended in a report released in late September that the commission consider revising its rules to require that hedge fund advisors register with the SEC under the Investment Advisers Act of 1940. The committee stopped short of recommending that hedge funds themselves be required to register.

Registration of hedge fund advisors would mean they would be subject to the SEC's regular inspections and examinations program. The SEC says it then could collect meaningful information about the funds and could require advisors to disclose information important to investors. Registration would effectively increase the minimum investment requirement for direct investors in some funds.

The long-awaited report was the result of an SEC fact-finding investigation spurred by concerns about the lack of information regarding hedge funds, the increased incidence of enforcement actions regarding hedge fund advisors and the potential for less sophisticated investors to become involved with the funds. The SEC estimates 6,000 to 7,000 hedge funds operate in the United States, managing approximately $600 billion to $650 billion in assets. In the next five years, hedge fund assets are predicted to top $1 trillion, it adds.

Currently, about 25% of all hedge fund managers are registered as investment advisors. Will registration of hedge fund managers under the Investment Advisors Act of 1940 have an impact on a fund's performance?

No, says Graves. He says there is no difference in the performance of hedge funds that have managers registered as RIAs and those that do not.

"It isn't performance related," says Graves. "(The Investment Advisers Act of 1940 is) for compliance and antifraud. The act contains various antifraud provisions, and requires advisors to meet record keeping, reporting and other requirements."

With limited public information available on hedge funds, it's important for financial advisors interested in them to do exhaustive due diligence.

"Hedge funds will perform better than open-end [hedge-like mutual] funds because they have no restrictions," says Matthew Rich, a former hedge fund manager who just launched the Technical Chart Fund, a registered open-end long/short fund. "I didn't realize how much of a difference there is between the investments. When I ran the [unregistered] hedge fund for Kauser Capital, I could short more stocks than I could with my Technical Charts Fund. I could use more leverage to boost returns. Plus, when you run a mutual fund, you have to find ways to keep the trading costs down."

But registered open-end funds may be an attractive alternative for those who are not accredited investors or for skeptical investors who are uncomfortable with unregistered investments. For example, over three years ending in 2002, the seven hedge-fund-like mutual funds tracked by Morningstar and Hedgefund.net on average gained 27%. By contrast, the S&P 500 lost 43%.

Rich stressed such mutual funds "are a good noncorrelated asset," and added that many investors are skeptical about turning their money over to unregistered investments. "Open-end funds are a good alternative."

It's not an easy task to invest in an unregistered hedge fund. Of the approximately 7,000 hedge funds, only about 2,000 are tracked by public databases. There are questions about the reliability of their performance data.

"There is no central source for listing funds," says John Mauldin, president of Millennium Wave Investments in Fort Worth, Texas, a consulting firm that studies hedge funds. "Finding the style that is right for your investment needs is critical. Some hedge fund managers are good and some are just lucky."

Malden, who conducts due diligence on hedge funds, says there is no standardized way of presenting hedge fund returns and risk statistics. He says he won't deal with a hedge fund that hasn't undergone a full audit by a nationally recognized firm or a well-respected niche firm, like Arthur Bell in Baltimore, or Rothstein-Kass in Roseland, N.J.

Thomas Keesee, principal with CDK Investment Management LLC of New York, which manages three private-placement funds of hedge funds, says one common problem is hedge fund managers may stray from their investment strategies. "You will see some shifting of strategies, and the manager is not upfront reporting about it," he says. "Some managers will tell you what they own. Others may give you only some of the information."

Keesee says that one of the keys to judging hedge funds is to determine whether there are any "dislocations in monthly returns." Consistency of returns is particularly important with hedge funds that invest in illiquid securities. He first wants to see how many price quotes exist on the securities the hedge fund owns.

Mauldin avoids funds with computerized trading strategies that are often called "black box" investment methods. The reason: The investment can be a blind pool. In addition, he questions the reliability of the input data used to make investment decisions.

He stresses that it is important to take a close look at the hedge fund's custodian bank. Are the operations sounds, and does it have a number of well-respected clients?

"You have to be skeptical," he says. "Long-Term Capital (which was bailed out with Federal Reserve help in 1998 before its subsequent failure) used a black box to invest. You had no idea what you were investing in. The principals of the firm were Nobel Prize winners. Everybody trusted them. But the fund went bankrupt."

He says there are about 500 hedge funds he would recommend. But he suggests pulling the plug on the fund the moment the fund's risk statistics deviate widely from their historical returns.

"Even if a fund has a great long-term track record, you have to look at what it is doing," he says. "I won't mention any names, but there is a distressed securities fund that has been doing well for years. The fund is a crapshoot. They will buy, for example, distressed debt from Nicaragua on the Romanian market for 10 cents on the dollar. Next they ask the Nicaraguan government if they would like to buy back their debt for 20 cents on the dollar in pesos. Then the hedge fund will go to a big corporation that is developing property in the country and sell them pesos for 40 cents on the dollar."

Don Goldman, chief financial engineer at Measurisk, a New York-based risk evaluation service, says there are a number of problems with hedge fund data. For example:

There is a danger of misinterpretation or misapplication of the data based on measures of risk.

The amount of assets under management can be distorted because of leverage. You should look for capital under control or capital subject to some form of risk.

Hedge fund performance can be distorted by the fee structure, how security positions are marking to market and how illiquid securities are priced. "Many hedge funds," he said, "do not have the tools to price illiquid securities and depend on the dealers for pricing." Plus many funds of funds are not capable of separate pricing.

Survivorship bias distorts hedge fund data. The data is biased because funds that fail are dropped from the databases. He estimates the hedge fund failure rate ranges between 4% and 25% annually. So the returns on the remaining funds and risk measures have an upward bias. "The bottom line is that when you look at survivors, you see higher Sharpe ratios associated with higher leverage," Goldman said. "Funds might look less risky than they are simply because they are still alive."

Michael Clouser, finance professor at Lynn University in Boca Raton, Fla., suggests reviewing a hedge fund's due diligence report before you start your own investigation. In addition, you should talk to the limited partner of the hedge fund; limited partners in private equity and venture capital deals may talk to investors.

"Unlike their private equity counterparts, most hedge fund managers are unwilling to provide the necessary disclosure on an ongoing basis so that investors feel comfortable," Clouser says.