It's no secret that, in the bear market that started 16 months ago, hedge funds managed to live up to their names. Many even produced positive returns in 2000. The same can't be said for the majority of equity mutual funds or separate accounts.

That may explain why many advisors suddenly are looking more closely than ever before at hedge funds as an alternative investment for their clients. Even if advisors aren't going down that road, they are hearing from clients, who are disappointed about the performance of their portfolios over the last year and are clamoring for alternative investments like hedge funds.

Alternative investments were the subject of a late-June symposium in Chicago sponsored by Undiscovered Managers in Dallas. (In the interest of disclosure, Undiscovered Managers CEO Mark Hurley has contributed several articles to Financial Advisor.) His firm also is creating a fund-of-funds platform through which it hopes to offer groups of pre-selected hedge funds to advisors who use Schwab Institutional, CSFBdirect Institutional, TD Waterhouse Institutional or Fidelity Investments Institutional Brokerage Group. In some advisors' minds, the Undiscovered Managers meeting generated more doubt about the viability of hedge funds than enthusiasm for the sexiest investment vehicles among the jet-set crowd.

One of the more provocative speakers at the conference was Thomas Schneeweis, a professor of finance at the University of Massachusetts and director of its Center for International Securities and Derivative Markets. Schneeweis also runs a consulting firm providing analytical support for multifund creation. He has emerged as something of an expert on measuring hedge fund risk and performance, and he voiced skepticism about the ability of most hedge fund investors, legally defined as "sophisticated," to understand these concepts.

As often as not, it's the strategy, not the manager, that is the single most important determinant of success. "[But] people don't say, 'I have a great strategy'; they say, 'I have a great manager.' They say, 'George Soros is a buddy of mine,'" Schneeweis explained, adding that, in reality, Soros oversees about 40 hedge fund managers. "Managers don't say what they do; they say they are wizards. As Dorothy found out in The Wizard of Oz, there are no wizards."

Indeed, if mutual fund managers seem reticent about describing their investment styles and strategies, they are downright extroverts when contrasted with their hedge fund counterparts.

Many claim to specialize in a given strategy, say corporate transactions/risk arbitrage, distressed securities or global currencies, but they have broad charters that essentially permit them to invest wherever they want. Accordingly, Schneeweis urged advisors trying to evaluate hedge fund managers to focus on the source of their returns, not the historical data. After five years of 20%-plus returns in the late 1990s, it's not surprising that many hedge funds have some impressive performance numbers about which to boast.

Schneeweis told attendees that applying traditional risk-measurement techniques to hedge fund evaluation could be deceptive. "Low beta doesn't mean low risk," he said. "Sharpe ratios and betas can be measured, but they aren't as significant as how the strategies perform in certain kinds of markets." Often, the top managers look quite similar over two-year periods.

The investing public's appetite for hedge funds is growing voracious, and that's a source of concern to many advisors and other financial professionals. "All a mutual fund manager needs today is one good year, and he can go start his own hedge fund," says Bill Villafranco, a financial advisor who oversees $800 million in client assets in Woodcliff Lake, N.J. "Most of them are quite young and have no experience in running a business."

To staunch the hemorrhaging of top managers, several investment companies have let star mutual fund managers stay with the company and open their own hedge funds. In early July, OppenheimerFunds acquired Tremont Advisers, which manages $8 billion in 13 proprietary hedge funds. Such moves are likely to begin to "professionalize" the management and business practices of what is a cottage industry, but there's a long way to go.

To fill this void, many large securities firms recently have entered the fast-growing prime brokerage business in which they act as both a marketer/fund raiser and a bank for young hedge funds. They provide accounting services and support to establish a back office for 30-year-old hot-dog managers. Often, they get a slice of the typical 2% management fee for all the assets they raise. Prime brokers arrange meetings for hedge fund managers with both service providers and wealthy potential investors. A recent cocktail party that Arthur Andersen threw in New York City for wannabe hedge fund managers was packed.

The manic behavior of managers and investors was also the subject of a recent commentary by Barton Biggs, senior strategist at Morgan Stanley and a one-time hedge fund manager himself, titled "Looking Into The Hedge Fund Bubble." Biggs estimates there are 6,000 hedge funds averaging just under $100 million in assets around the world. Many are "leveraged up to who knows what." Perhaps even the manager doesn't know. Biggs also notes that some of the "really hot" funds recently increased their take of the funds' profits, from a hefty 20% to an outrageous 50%, partly because they don't want more money. In an elliptical warning, Biggs observes that prime brokers "don't have stakes in the funds themselves."

Many, but not all, of the best hedge funds with long track records are closed to new investors. Unfortunately, the true stars of the hedge fund universe aren't nearly as generous to the prime brokers and fund-of-funds consultants as the rookies are. "Last week, a famous late-50-ish hedge fund manager with a very good record told me he is getting no new money, but in the last few months, two of his young guys [who'd been with him three to four years and in an average year made $10 million to $30 million] have quit to start their own funds. Each raised $250 million to $300 million from funds of funds and consultants," Biggs writes. Some might call this tale sour grapes from Wall Street's Grumpy Old Men's Club, of which Biggs is secretary, treasurer, president and chairman of the board. But it carries more than a few kernels of truth.

He isn't the only one concerned about the problems brewing in three of today's most popular strategies, long/short equities, distressed securities and convertible bond arbitrage, in which a fund typically buys convertible bonds and shorts the underlying stocks. Michael Lewitt, chief operating officer of Harch Capital Management in Boca Raton, Fla., is particularly worried about funds focusing on the latter two strategies. "Neither are that liquid," he says, adding that only the macro and equity risk arbitrage strategies enjoy deep liquidity. "They will be the next disasters. Money chases returns, which creates structural problems. Then returns will go down, and it blows up."

Lewitt himself converted his firm's high-yield, value-oriented bond fund from a hedge fund to a more traditional long-only separate account. "The biggest risk with hedge funds is how redemptions are handled," he notes. "It's inevitable that people will want to pull out their money at the worst possible time." And at the most illiquid time.

For all of the drawbacks of hedge funds, several advisors at the Undiscovered Managers symposium say they have enjoyed varying degrees of success with them and other alternative investments, although these vehicles require more time and involvement than traditional securities.

Richie Lee, principal at the fee-only firm of Lee Financial Corp. in Dallas, cited risk management and diversification as two reasons he uses alternative investments. "Years ago, back in 1972, the universe of opportunities was wide. My entire career has [occurred] during periods when interest rates are high. Now they are not," Lee said. "The risk of managing money for older people is going up."

Lee Financial administers 45 limited partnerships and gets involved in these vehicles to a degree that would frighten many advisors. Lee regaled attendees with a story of purchasing barges used in oil drilling in the late 1980s at a fraction of their initial cost before finally unloading them at a profit to George Soros, who then earned an even larger profit. "Don't believe you can't make a difference," Lee, who puts about 40% of clients' assets in a variety of alternative investments, told attendees. "Our size versus institutions can work to our advantage."

Another advisor, Robert Levitt of Boca Raton, Fla., bemoaned the waves of institutional money flooding certain types of hedge funds. "We don't want exposure to long-short equity funds of funds," he said.

Levitt urged advisors to "find guys with a simple strategy," adding that if you can't figure out who the sucker is, there's a good chance it might be you. "Try to understand one type of strategy at a time," he continued. "We have a guy who was a utility-deregulation consultant who now runs a market-neutral utility fund."

Over the last three years, Levitt has placed between 20% and 50% of clients' assets in hedge funds, and he acknowledged that it was an educational experience. He also admitted making several mistakes at the beginning and was fortunate enough to be bailed out by what, at the time, was still a roaring bull market.

Even if another disaster of Long Term Capital Management proportions occurs, as many are predicting, interest in hedge funds is unlikely to wane. The best brains in the investment world are flocking to these vehicles, and wealthy investors know that all too well. The growing realization that the era of double-digit returns on equities is over, at least for now, is placing more pressure on financial advisors to find alternatives. But as Lee noted, risks are rising as well, so vehicles that have the flexibility of selling short have a strategic advantage.

To remain competitive, more mutual funds and separate accounts are broadening their investment charters. Take the Needham Growth fund, a quasi-tech fund that was up 7.4% in 2000 and 11.5% in 2001, as of July 9, with about 58% of its assets in, yes, technology. How did it pull off such a feat? By going up to 25% short and holding nearly 15% of its assets in cash.

If more traditional investment vehicles start thinking outside the box like the Needham fund, hedge funds may inevitably lose some of their cachet. For now, however, they stand out as the belle of a rather dowdy ball. And they'll probably break a few hearts-and wallets.