Accredited high-net-worth individuals haven't generally been eager to jump into hedge funds-and it's hard to blame them.

Many have never learned much about these vehicles, which have a limited ability to market themselves, and don't know where to begin, says Jack Killion, a general partner at Eagle Rock Partners LLC, a fund of hedge funds manager in Long Valley, N.J. Financial advisors often don't know a lot about them either, or are restricted by their firms from recommending them.

Nor are the industry's well-publicized scandals and poor performance exactly selling points. The HFRI Fund Weighted Composite Index, a commonly used benchmark, fell 4.8% in 2011, its second annual decline in four years.

Steep minimum investments and capacity limits have also deterred investors, as has the global financial crisis. At the end of 2010, the wealthy had just 5% of their financial assets in alternative investments, including hedge funds, down from 10% in 2006, according to the 2011 World Wealth Report from Capgemini and Merrill Lynch Wealth Management. Hedge fund holdings accounted for 24% of their alternative investment assets in 2010.

But it may be time to take a closer look at the maturing industry. Hedge funds embrace a wide variety of strategies and niches, some more conservative than you might expect. They're also coming under greater scrutiny because of the Dodd-Frank act and other legislation. Additionally, the industry is putting more emphasis on operational best practices, compliance and investor communications as its institutional assets grow.

These were the big takeaways from a hedge fund conference recently co-sponsored in Florham Park, N.J., by Eagle Rock Partners and professional services firm Rothstein Kass. Managers of 11 hedge funds (two held by the Eagle Rock Diversified Fund LP) spoke to an audience of mostly accredited high-net-worth investors, as did wealth advisors invested in this space.

So how are hedge fund managers approaching different niches, and what's their big appeal?

Some funds focus on reduced volatility and increased return. These are the main benefits of the Gargoyle Hedged Value Fund, for instance, which buys undervalued U.S.-listed companies and sells relatively overpriced call options on the S&P 500, the Nasdaq and the Russell 2000 indexes. The strategy works well because index options are overpriced more than 80% of the time. "This is one of the worst kept secrets on Wall Street," says Josh Parker, managing partner of investment strategies at The Gargoyle Group, a 24-year-old Englewood, N.J., firm that specializes in options.

The drawback with these options is that if the market goes up a lot, you've capped your upside potential. But the options smooth out the rate of return over the long term and reduce volatility by 20%, Parker says. The strategy also provides Gargoyle with some tax efficiencies, although he notes that index options aren't always tax-advantaged.
Why value stocks? "It's a slow, steady, conservative approach," says Parker, whose fund holds a basket of about 100 stocks. "We're not top-down guys, we're bottom-up." 

High-yield debt in emerging markets and distressed debt are the focus of Greylock Capital Management LLC, an SEC-registered investment advisor with operations in New York, Singapore and Ghana. "If you see a crisis and everyone swings to the exit, we go in," says Hans Humes, president and chief investment officer.

Greylock, which jumped into Asia in 1997 and Russia in 1998, took an investment position in the Middle East in late 2009 and now has about 20% of its assets there. "The absolute returns are very good, there's not a lot of competition and it trades in its own world, insulated from the macro moves in other markets," he says.

Humes sees no shortage of opportunities. "Our universe is exploding," he says, noting that roughly $600 billion in high-yield debt was issued in emerging markets in 2011, up from $344 billion in 2008. He also expects to see a lot more workouts on the distressed side.

Greylock doesn't use any leverage and it works with people on the ground, such as government officials, financial institutions and industry experts. "You don't want to do it alone in the Middle East and Greece," says Humes, who's on a steering committee involved with the Greek debt negotiations.

Boston-based IBS Capital LLC, meanwhile, pursues an event-driven strategy with focuses on distressed debt and turnaround stocks. "It looks like vulture investing, but the reality is guys like me are digging around trying to find the diamond in the rough," says David Taft, president. When investing in Russian natural gas company Gazprom in the late 1990s, he saw the possibility for rebounding oil and gas prices, a macroeconomic turnaround in Russia, and a corporate reorganization and management overhaul-all of which happened between 1999 and 2006.

Taft, who doesn't use leverage, prefers a concentrated position and typically holds investments two to five years or longer. He currently has about 15 positions, mostly in the U.S. He feels wealthy investors who don't plan to spend their money soon are better off taking a longer-term mindset and not getting hung up on liquidity and diversification. He's seen family offices with 50 hedge funds. "If you don't know what you own, that can get you into trouble," he says.

Martin Friedman and Andrew Jose, co-founders of McLean, Va.-based FJ Capital Management LLC, spent a combined 40-plus years in the banking industry before launching the FJ Capital Long/Short Equity Fund in January 2008. The fund, which has a long bias, invests in the publicly traded stocks of U.S. community banks with market capitalizations of $1 billion or less.

"Community banks are eating the lunch of larger banks," says Friedman. Meanwhile, the fund's average portfolio holding is trading at just 70% of tangible book value, versus the 2 to 2.5 times the sector traded at four to five years ago. He and Jose expect to see more consolidation among its roughly 1,100 remaining banks. Their fund mostly targets banks that are building franchises through mergers and acquisitions. "The takeout is the icing on the cake, not the focus," says Jose.

Other niches discussed at the hedge fund conference included global convertible bonds, mortgage-backed securities, health care and technology.

Advisor Outlook
Jordan Heller, president of Heller Wealth Advisors, a fee-only firm with offices in Roseland, N.J., and New York City, is pleased by the expansion of the hedge fund industry. "When I first entered the wealth management business in 2000, I was immediately drawn to them and the selection has only grown," he says.

The former institutional research analyst says he's attracted to hedge funds' risk-reward dynamics. About 20% to 40% of his typical client's investment portfolio is in alternative investments, including hedge funds. Without them, he says he would've had much more volatility in the past four years.

Heller invests in multi-strategy hedge funds and ones that focus on long-short equity, managed futures, private equity and distressed debt. For liquidity, he also uses registered mutual funds that apply hedge fund strategies. Sometimes he uses feeder funds, which allow lower minimums. He also wraps hedge funds in insurance to eliminate taxation.

While longer-term track records have helped him become more comfortable, he continues to approach the hedge fund space cautiously. He uses credible, trustworthy platforms and his firm has a research analyst dedicated to alternative investments.

Jack Sullivan, CEO of Heritage Wealth Counselors LLC, a Boonton Township, N.J.-based registered investment advisory firm focusing on high-net-worth families, has been investing in hedge funds for clients for seven years. The family office he runs has 40% of its assets in them.

His strategies include distressed debt, debt arbitrage, U.S. long-short equity, futures, event-driven investments, merger arbitrage and mortgage-backed securities. "We like to pick areas that we want to complement our portfolio of investments," he says. Because he was once the victim of a Ponzi scheme, he stresses due diligence and getting to know fund managers. "Having a bad experience preps you," he says.

Manager's Choice
Killion, who founded the Eagle Rock Diversified Fund 11 years ago, makes sure he understands a fund's strategy and how it manages risk before investing in it. He also asks who audits it, how much leverage it has and if he'll have access to its top decision-makers if he has a problem. He's gotten out of some funds. "You have to like, trust and be a real partner with the managers you invest in," he says.

He also wants to see three years' performance before investing in a hedge fund. "Most of the blowups occur in the first three years," says Killion, who formerly was a consultant for Fortune 500 CEOs and has started and headed businesses in various industries.

Eagle Rock's eight holdings include small cap, mid- and large cap, long-short equity, event-driven investments, emerging growth, emerging markets debt, high-yield debt and Western European debt funds. "I go to sleep at night feeling pretty good with eight sets of minds working for us," says Killion.