Some advisors are using hedge funds to minimize risk, not boost returns.

One might think the end of a three-year bear market would have short-circuited the hedge-fund boom-some call it bubble-in 2003. But it didn't happen.

Interest in these vehicles among financial advisors continues to vary widely, but more advisors are using them and not for the reasons observers might think.

To put it bluntly, they aren't seeking to hit home runs for clients. Take Tim Kochis of Kochis Fitz, a San Francisco advisory firm with about $900 million in assets under management. The firm invests about 15% of clients' assets in hedge funds, or fund of funds. When it comes to ranking them on the risk spectrum, Kochis considers the funds his firm uses less risky than long-only equities, but adds that they also offer lower returns.

The hedge fund managers he uses are hardly the gunslinging, shoot-the-lights-out style investors lionized in the popular media. Most seek returns of 6% to 12% a year, 0.5% to 1% a month. Absolute return hedge fund of funds can be viewed as "a good alternative to fixed-income investments," Kochis explains. "We want predictable returns, and a hedge fund that gets 70% one year is obviously unpredictable."

Funds that are more consistent and less spectacular just may fit the bill. "The fund of funds we use might have two negative months in four years, and the negative [return] months are fairly small and easy to recover from," he adds. "On an efficient frontier, absolute return fund of funds would be slightly above the curve. If you put them into an optimizer without any constraints, it would say go 100% absolute return hedge funds."

But like most advisors, Kochis has long recognized that an unconstrained optimizer is a disaster waiting to happen. He also acknowledges that hedge funds possess several drawbacks. The biggest probably is their tax inefficiency, which is why Kochis prefers placing them in qualified accounts. Illiquidity comes in a close second. A third reason, Kochis says, is that "we don't expect them to be as high a return vehicle as long-only equities."

Finally, clients who have bought into the firm's mantra often note that absolute return strategies clash with many basic tenets of financial planning, and represent a departure from traditional advice about maintaining a stable asset allocation and avoiding market timing. "It's a fair question," Kochis concedes. "We say, 'This is a hedge.' The funds are selected so they can get positive returns in down markets, and they've been doing it."

The strategy that Kochis is employing is being embraced increasingly by giant institutional investors like pension funds and endowments. They are reasoning that in an era when many expect to earn mid-single-digit returns from equities and bonds, the additional flexibility of hedge funds may permit these vehicles to generate high-single-digit returns. Kochis still believes that in the long term long-only equity will outperform hedge funds and so has allocated a higher portion of clients' assets to that arena.

Relatively conservative institutional investors are whistling the same tune as Kochis. "Endowments and foundations have embraced hedge fund managers," says Charles Palmer, a performance analytics consultant to large institutions at CPSoftware in La Quinta, Calif. "What they are trying to do is mix different assets that are not highly correlated. It's understandable why absolute returns are an attractive alternative, and they are a nice pitch for salesmen, but are people just chasing a new strategy after three lousy years?"

Yet most advisors are taking a far more cautious approach than is Kochis. Lou Stanasolovich, CEO of Legend Financial Advisors in Pittsburgh, is using several fund of funds, but only for a handful of clients with more $2 million in assets. No more than 5% of clients' portfolios are allocated to hedge funds, which contrasts with Kochis' maximum limit of 25%.

The three groups Stanasolovich is using are Rydex, Man Investments and Undiscovered Managers, which has a $40,000 minimum. Like the institutional investors described by Palmer, he is looking for noncorrelated assets. "But so much stuff has very short track records, and you devise portfolios of mutual funds with long track records of uncorrelated returns," he says.

Another problem advisors cite about hedge funds' performance statistics is so-called survivorship bias. Many funds that are launched flounder and ultimately fail, and performance results for a particular class or strategy are overweighted with the winners, which have outperformed their peers. Good luck to any financial advisor trying to get into those funds. "The best managers don't want any more money because they want to remain nimble and earn their income off of performance appreciation," explains one fund of funds executive. "The mediocre ones want to raise big bucks and get paid off the performance fees."

How extensively are advisors using hedge funds? Fred Whaley, managing director and head of alternative investments at Raymond James Financial Services in St. Petersburg, Fla., reports that about 18% of the firm's 5,000 or so reps are using them.

"We look at hedge funds that reduce volatility and serve as a financial planning tool that's part of the asset allocation model, not ones that use leverage and concentration to generate returns," Whaley says.

Typically, he seeks funds of funds that produce overall equity-like returns with lower volatility. That means the fund of funds will frequently have annual returns of 8% to 12% but volatility of 4% to 6% rather than the 12% to 17% volatility that individual funds within the fund of funds might display. Whaley also says funds with a seven-year track record give him a chance to evaluate their performance in almost every kind of environment imaginable, although he has to look behind the numbers to see how they got their returns.

For many advisors, navigating their way through the hedge fund maze can be a frustrating, time-consuming process. The hedge fund universe encompasses a broad array of different strategies ranging from distressed securities to convertible arbitrage to global macro.

By far the dominant strategy, however, is long/short equity investing. Expertise and performance vary widely. "Most have a long or a short bias because if you try to be completely market neutral, you can lose your caboose to transaction costs," explains one sponsor of a fund of funds. "The real value-added comes on the short side. Many managers who come from a long-only background like mutual funds tend to be very poor short sellers. So they will use index options or futures as a substitute for substantive short positions."

On average, long/short equity hedge funds appreciated about 20% in 2003, compared with 28.3% for the Standard & Poor's 500 Index, according to Jeff Joseph, managing director of the alternative investments group at Rydex Capital Partners in Chicago. "It's a strong validation of the space," he argues. "They [long/short equity hedge funds] did it with less risk than the S&P 500."

One new trend that emerged in 2003 was the advent of hedge-fund index funds. This group raised more than $1 billion last year. Among those developing hedge-fund index funds were Rydex, Morgan Stanley, and CSFB/Tremont. Dow Jones Indexes is reportedly developing its own benchmark.

"Hedge fund indices offer more protection than most fund of funds," Joseph says. Indeed, the odds of having a hedge fund implode upon advisors' clients is reduced by investing in an index. However, if discombobulations affect the majority of hedge funds devoted to a single strategy, like global macro, it probably will be reflected in the index's overall return.

Echoing Kochis, Joseph acknowledges that the image of hedge funds painted in the popular press, generating triple-digit returns with huge leverage one year and getting slamdunked by that same leverage and a shift in the winds of the market the next year, is often at odds with the reality of the business. "Most institutions won't go near a fund that is up a lot more than 20% in any given year," he says.

Financial markets are in a continual state of flux, so it's not surprising that different styles or strategies move in and out of favor. The hottest strategy at the moment is Japanese long/short equity, largely because regulators in Japan just began to permit short sales of stocks.

Last year as the economy emerged from a recession, the fixed-income arbitrage arena produced robust returns. "All the accounting scandals of 2002 widened credit spreads, took a lot of bonds down and created many opportunities," says Cynthia Nicoll, senior vice president of investment management at Tremont Investments, adding that market evolution has also enhanced opportunities. "Today there is more of a tradable repo market and a deeper defaulted credit market." But she also cautions that we are now in "a different point in the cycle than we were a year ago," so opportunities could be moving elsewhere.

Lastly, there is the regulatory landscape. Two years ago, the subject of increased regulation of hedge funds was among the hottest in Washington. Then came the accounting scandals followed by the mutual fund scandals, in which a handful of hedge funds played a central role.

The mutual fund scandal may have moved the issue of hedge fund regulation to the back burner, but that's likely to be temporary. "The issue of what is appropriate transparency will resurface later this year," predicts Nicoll. If new regulations increase transparency, she and others suspect it will bring a lot of new money into the business.