Rich stressed such mutual funds "are a good noncorrelated asset," and added that many investors are skeptical about turning their money over to unregistered investments. "Open-end funds are a good alternative."
It's not an easy task to invest in an unregistered hedge fund. Of the approximately 7,000 hedge funds, only about 2,000 are tracked by public databases. There are questions about the reliability of their performance data.
"There is no central source for listing funds," says John Mauldin, president of Millennium Wave Investments in Fort Worth, Texas, a consulting firm that studies hedge funds. "Finding the style that is right for your investment needs is critical. Some hedge fund managers are good and some are just lucky."
Malden, who conducts due diligence on hedge funds, says there is no standardized way of presenting hedge fund returns and risk statistics. He says he won't deal with a hedge fund that hasn't undergone a full audit by a nationally recognized firm or a well-respected niche firm, like Arthur Bell in Baltimore, or Rothstein-Kass in Roseland, N.J.
Thomas Keesee, principal with CDK Investment Management LLC of New York, which manages three private-placement funds of hedge funds, says one common problem is hedge fund managers may stray from their investment strategies. "You will see some shifting of strategies, and the manager is not upfront reporting about it," he says. "Some managers will tell you what they own. Others may give you only some of the information."
Keesee says that one of the keys to judging hedge funds is to determine whether there are any "dislocations in monthly returns." Consistency of returns is particularly important with hedge funds that invest in illiquid securities. He first wants to see how many price quotes exist on the securities the hedge fund owns.
Mauldin avoids funds with computerized trading strategies that are often called "black box" investment methods. The reason: The investment can be a blind pool. In addition, he questions the reliability of the input data used to make investment decisions.
He stresses that it is important to take a close look at the hedge fund's custodian bank. Are the operations sounds, and does it have a number of well-respected clients?
"You have to be skeptical," he says. "Long-Term Capital (which was bailed out with Federal Reserve help in 1998 before its subsequent failure) used a black box to invest. You had no idea what you were investing in. The principals of the firm were Nobel Prize winners. Everybody trusted them. But the fund went bankrupt."
He says there are about 500 hedge funds he would recommend. But he suggests pulling the plug on the fund the moment the fund's risk statistics deviate widely from their historical returns.