There are plenty of investing options available to astute financial advisors.  The realm of alternative investments is large. It includes investment vehicles such as hedge funds, venture capital funds and private equity funds. These offer unique advantages but they come with risk profiles different than those of mutual funds and exchange-traded funds.  

What Are Hedge Funds?
In this article, we will take a look at hedge funds in particular. Various types of hedge funds have been in existence for the past 50 years. The original intent of this investment category was hedging of portfolios of stocks or bonds, but the term today refers broadly to any private investment fund that has a fixed management fee based on asset size and an incentive profit-sharing arrangement. If you look at hedge fund databases (provided by Bloomberg, Morningstar or other firms), you will see classifications like directional equity, global macro, event driven, fixed-income arbitrage and so on.  The terminology can be intimidating, but in essence, these funds invest long and short in stocks, bonds, currencies or commodities, in the U.S. or globally, sometimes hedged by indexes, futures or ETFs.  

Why Should You Consider Hedge Funds?
Properly researched and selected hedge funds should be a part of a balanced portfolio for affluent investors. Please keep in mind that hedge funds can be offered only to accredited and qualified investors, i.e. those with net worth above $1.5 million (there are other criteria for accredited investors but this is the simplest and superceding requirement). Mutual fund and ETF investing can be great during bull markets, but they do not have downside protection or hedging, which is provided to some degree by many equity long-short funds. Second, a hedge fund manager usually has a strong incentive to perform well to achieve absolute returns.  Mutual funds on the other hand, are focused on returns superior to benchmark indexes. In 2008, many hedge funds performed better (or less badly) than mutual funds and market indexes. Hedge funds also provide you with investing strategies not available through other kinds of investments.

Five Steps To Selecting Hedge Funds
Investing in hedge funds is not easy. Unlike mutual funds, there is little or no information available publicly on hedge funds, and that makes the task challenging for financial advisors. On the other hand, if you perform solid due diligence in selecting, you bring a significant value to your clients. Here are guidelines to use in narrowing your search:

Step 1: Understand Investment Philosophy
This may sound trivial, but it is amazing how often investors put money in funds recommended by their friends without knowing what the fund is really about, what type of assets it invests in, and importantly, what are the parameters under which it operates.  

However, it's often not easy to find detail information on hedge funds. Their reporting requirements usually aren't as detailed as those for mutual funds. But there are a few ways to dig for more for information. The first is to talk to the manager and ask pertinent questions. Another way: Read past letters or quarterly reports sent to fund investors by the manager. Usually, a hedge fund manager will provide them to you when you request them (we do so), and they can offer insight into the hedge fund's investing philosophy by way of examples. Fund managers are generally reluctant to tell you about current positions, because making them public might result in others taking action that could hurt their strategies, especially for shorts. But if you are told the fund manager has proprietary trading techniques, or some esoteric formulas and gumbo-jumbo that are too difficult to explain to investors, that should raise a red flag. Stay away from black boxes (or should we call them Maddox boxes). True, some investment strategies are not simple, but if they are truly worth applying, you must spend time with the fund's offeree to understand well what the fund is about.

Step 2: Understand The Risk
Read offering documents (prospectus) carefully. What are the risks, what can go wrong? A well-known example is Amaranth, a multibillion dollar fund that lost over 50% in a matter of weeks in 2006 as its bets on natural gas futures turned disastrous. That fund used too much leverage and had concentrated bets - factors that amplified risk.  

Assessing risk is tough. You have to ask questions. How much leverage does the fund utilize? What criteria does it follow for maximum exposure to a single security? How well does the fund manager execute its strategy? What checks and balances do they have in place?  Leverage is a two-edged sword. Some fund managers get carried away with it, believing too much in their strategy. If it works, they are rewarded, if it does not work, the downside risk is higher compared to those funds that have little or no leverage.

Step 3: Assess The Manager

This is the most critical step. What qualifies this manager and his or her firm to invest your precious money? What is unique about this fund manager's firm and its principals?  What is the background and experience of its principals?  Fund salesmen are often good communicators with charming personalities, but you have dig deeper and evaluate the manager.

It is preferable to invest with fund managers who are registered investment managers. You can find information about them on the SEC Web site (for both state or SEC registered). There is usually some due diligence done on them by regulators. You can, and you should review their filings (ADV 1, ADV II) prior to investing. It is also preferable to invest with managers who are either CFAs or have completed Series 65 certification (the investment adviser law exam). Both these emphasize various investing factors with investor interests as the primary concern (such as fiduciary responsibilities, portfolio concentration etc). Often, RIAs have one of these certifications. Contrast this with fund managers who are not RIAs. There is little or no information about them, and no due diligence done to verify their information.

Sometimes, we see people with a pedigree of a big name Wall Street firm that's launch a fund. Their ideas may be great, but if they lack significant and proven expertise in money management, they will be like a rookie quarterback trying to run a complex offense. If you still find such managers' offerings attractive, it is prudent to start small and let them prove themselves and their strategies.

Step 4: Choose Independence And Non-affiliation
It is desirable to invest in funds that have an independent and well-known custodian, and an independent accountant (third-party administrator). The fund manager and the offeree of the fund should not be affiliated with the custodian of the fund's assets. This simple step is important in protecting against possible frauds.

The fund's asset valuation is done on a periodic basis, usually monthly.  It is best to opt for funds that use outside, experienced accountants for calculating net asset values. It is preferable to opt for a fund that is audited annually by independent auditors.  For fund managers who are RIAs, an annual audit is usually a regulatory requirement.  That is another reason to prefer funds offered by RIAs.

Step 5: Review Past Performance But Do Not Excessively Rely On It
It is important to review past performance and understand why the fund performed well or not well. Of course, past performance is no guarantee of future results, but it will give you insight into the fund's management philosophy.  When you evaluate returns, it is important to look at time periods and compare them to peers. For example, if some one says, our fund is up 50%, ask him as of when - as of the first of the year? Or some other date? No cherry picking should be allowed. In short, review numbers carefully.

The five steps described above are a good starting point.  There are further considerations - what are fees, what are redemption policies, has the fund manager invested a sizable portion of his own money in the fund (that is a plus), what are the minimums, how will the fund fit into to your client's total portfolio. If your client has mostly long exposure at present, adding long-short hedge funds can reduce net long exposure and volatility.

Above all, as a financial advisor, before you invest your clients' money in a hedge fund ask yourself a simple question - would I invest my own money in this fund under similar circumstances? The answer should be a resounding yes before you recommend the fund to your clients.

Manoj M. Nadkarni is the president of ChipInvestor Group LLC (CIG), a registered investment advisor based near Seattle. CIG offers technology sector-specific investment management for high-net-worth persons, financial advisors and institutions. Nadkarni graduated from the Massachusetts Institute of Technology with a master's degree in engineering, and holds a Series 65 license. He can be reached at [email protected] or at (800) 676-4045.