The world of alternative investments is exploding, and no product is hotter than hedge fund of funds. The products, which on average have handily beat U.S. stock market indexes three years in row, promise to put together a complimentary slate of hedge fund managers and strategies that offer planners and their clients diversification they might not be able to afford from individual hedge fund managers.

With household names like American Express, First Union and UBS PaineWebber adding to their fund of funds offerings and others like Charles Schwab and Undiscovered Managers set to charge into the hedge fund-of-fund arena this year, the choices are growing by leaps and bounds. So is the industry's impetus. Two consecutive losing years in the stock market are draining away traditional mutual fund assets just as a reversion to the mean promises average annual returns of just 5% over the next five years.

There's also a fight in the financial arena to retain management talent. Mutual fund

managers are jumping ship to largely unregulated hedge funds in droves. There they can respond to weaknesses in the economy and the markets by selling much of their securities and holding large cash positions (strategies that mutual fund regulations clearly prohibit), as they did successfully in 2000 and 2001. And they're paid for it, earning on average 20% of their fund's net performance each year (the average administrative tab runs an additional 1% to 2%).

As critical in the drive to bring more hedge fund of funds to the market are investors themselves. The idea of buying a pool of professionally managed and hedged investment strategies has fueled investors' appetites. A new survey by Boston-based Spectrem found that 60% of investors with $1 million or more to invest are interested in hedge funds and, in the wake of slumping equity markets, have a strong desire for returns less correlated to standard benchmarks like the S&P 500. Still, a mere 7% of wealthy investors hold hedge funds, Spectrem says, which means the untapped market is significant.

With returns that handily beat the market three years in a row, hedge funds and fund of funds have become an enticing addition to many portfolios. Hedge funds gained 3.9% last year, according to the Hennessee Hedge Fund Advisory Group, compared with the dismal returns handed in by the Dow Jones Industrial Average (-7.10%), the Nasdaq (-21.04%) and the S&P 500 (-11.89). "We're putting hedge fund of fund performance at between flat and 5% to 6%," says Hennessee's president, Charles Gradante. While Hennessee builds customized pools of hedge funds for individual investors, the fund of fund concept is a good fit for investors with less than $5 million to invest, Gradante says.

The demand of high-net-worth individuals is precisely what's leading Schwab to roll out as many as four funds of funds in the next year, says spokesman Morrison Shafroth, who notes the company plans to use its independent advisory network to distribute shares.

The minimum investment in the fund of funds, which will be built and managed by outside consultants and managers, is expected to be as low as $50,000 to $100,000 and open to investors with $1.5 million in net worth.

American Express launched its third hedge fund late last December, the Global Market Neutral Conservative Fund of Funds Portfolio, with 17 separate hedge fund managers and a minimum investment of $100,000. The fund employs five investment styles: convertible arbitrage, volatility arbitrage, merger arbitrage, fixed-income arbitrage and equity market neutral.

UBS PaineWebber also launched a new hedge fund of funds, the UBS PW Equity Opportunities Fund II LLC, in December. The fund, which has a $250,000 minimum, aims to beat the three-month U.S. Treasury bill rate by 3% to 6%.

Face it: The latest evolution in the democratization of money management is being delivered on the backs of hedge funds of funds. Such growth is a mixed bag for planners who, with some notable exceptions, have shown steadfast reluctance to use hedge fund strategies in client portfolios. Simply put, the funds are nothing like mutual funds with their standardized performance reports and database services that can show you the best performers any day of the year.

Maybe that's why it's not surprising that only 17% of planners say they're knowledgeable about hedge funds. The time and resources it takes to do due diligence on hedge fund of funds managers is considerable. These products combine the styles and investment picks of an average of 10 to 25 hedge fund managers, each of who employs distinct and complex investment strategies.

While some have viewed hedge fund of funds as a less research-intensive alternative to hedge fund investing, experts say it's just not true. Doing due diligence on managers who put the funds of funds together is critical, says Lois Peltz, founder and president of Infovest21, a New York City-based information packager. "Some of these folks are marketing types. They may be great at raising money but lack crucial risk-management skills."

That's why knowing a hedge fund of fund manager's background is crucial.

Gradante suggests that planners go so far as to do a full-scale background check to see if any red flags turn up. "If the guy has a $10 million mortgage and you know he made $1 million a year at his last job, he might be prone to take added risk," says Gradante, who also looks for lawsuits, regulatory infractions and bankruptcies. Because some hedge fund managers have been known to fib about their funds' returns, Gradante routinely cross references fund managers' performance reports with their accounting firm's audited findings.

"It really can be difficult to enter this field cold," says Ron Lake, a principal of Lake Partners in Greenwich, Conn. His firm builds customized portfolios of hedge funds for clients and offers a pool of mutual funds that employ hedging techniques (the latter is called the LASSO fund, an acronym for "long and short strategic opportunities"). LASSO's three-year average annual return is 38%.

Still, with the bear market rumbling on, positive returns, even small ones, are enticing. "With more large financial institutions offering more products, does that mean that folks will invest in things they don't understand? It certainly opens up the possibility, but I really think it will make the industry more transparent overall," says Thomas W. Keesee, a partner in the New York City-based PH Chapman Advisors, whose Silver Cloud Limited hedge fund of funds racked up a smart 7.8% return in 2001.

With Schwab and Undiscovered Managers entering the fund of funds arena, due diligence should become easier, and performance reporting and fees more standardized. But for now, interested planners still have to create a system for doing their own research or find a third party they trust.

Well-respected financial planners such as Ross Levin of Accredited Investors, Edina, Minn., and Charles Haines of Charles D. Haines LLC, in Birmingham, Ala., have been doing research on hedge funds for years. While intrigued by the concept, they still are not ready to invest client money. "For sure, we won't be early adopters," says Levin, who is attracted to the notion of fund of funds but says the due diligence is too intense right now to make it worthwhile.

Haines has investigated launching his own alternative investments, but he is concerned with the dearth of good managers who employ short strategies. Like Levin and many other planners, the level of due diligence required is a turnoff. While no advisor who has invested in a hedge fund will dispute it, there are those who have not been deterred by the extensive due diligence. Timothy Chase, a principal of Wealth Management Services in Baltimore, had been investing client money in hedge funds for years when he decided to create his own small-cap hedge fund of funds in 1998 (he also launched a venture capital fund in 2000).

The firm now has $25 million in the fund, which uses six small-cap managers and has an average annual return of 11%. The idea for the fund came from clients and the firm's dissatisfaction with existing small-cap investments, Chase says.

That doesn't, however, mean that due diligence isn't a scourge. The firm spent months looking for new small-cap talent for its hedge fund of funds last quarter, and after talking to a narrowed list of 20, Chase spent "lots of time" interviewing about eight managers.

He wound up hiring no one. Wealth Management credits the 1% fee it charges on its small-cap hedge fund of funds back to client accounts. "We don't do this to increase fees," says Chase, "and sometimes I think I'm crazy because it's a lot of work, but ultimately it's the right thing to do for our clients."