A private placement fund of hedge funds that Richard Lee Jr. uses for clients returned nearly 20% last year. But that's not the only draw for Lee, who has worked the alternative-asset space for more than three decades and now presides over the 50-person Dallas advisory Lee Financial Corp. He knows that alternative investments in general are useful for controlling portfolio risk. With hedge funds in particular, "their ability to protect capital is as important as the returns," Lee says.

One classic hedge fund style or objective is to turn a specified profit, such as 10%, in any market-the so-called absolute-return strategy. The fund of funds Lee uses was in the black every month last year. And it hasn't posted a losing year in the decade or so he's been in it. Returns like that lead to low correlations with other asset classes.

According to Rydex Investments, the Credit Suisse/Tremont Hedge Fund Index had a correlation of 0.07 with both bonds and cash, 0.14 with commodities, 0.24 with REITs, and 0.49 with the S&P 500 from 1997 through 2006. During those 10 years, the hedge fund index averaged a 10.48% annual return with a 7.22% standard deviation, compared with the S&P 500's 8.42% return and 15.35% standard deviation.

In addition to making portfolios more efficient, they may also help to differentiate your advisory firm. Only 13% of registered investment advisors used them in 2007, according to Tiburon Strategic Advisors, market researchers in Tiburon, Calif. Just 6% of independent reps did. A forthcoming survey of the Financial Planning Association's practitioner members is expected to show that only 5% maintain hedge fund allocations.

Although not that popular with RIAs, many investors are interested in them. The $1.87 trillion hedge fund industry enjoyed record net inflows last year, which were up 54% from the record set in 2006, according to Hedge Fund Research Inc.

But practical issues exist for both advisors and clients. A firm that's considering advising about hedge funds has to carefully mull whether the benefits will outweigh all the costs, not merely the obvious ones like investment-management fees. Sometimes the alternative investment is not cost-justified, Lee cautions.

However, some of the traditional problems with investing in hedge funds have been mitigated, and in some cases surmounted, by recent trends. For instance, the open-architecture advisor platforms now provided by some of the major custodians have improved access to the funds and eased handling them in client accounts.

Meanwhile, according to Lipper, a Reuters company, some 239 different publicly traded open-end funds, generally non-diversified, now pursue hedge-fund-style objectives. That's more than double the number available three years ago, and what's better is that these proliferating funds offer lower minimums for the everyman. "These products resolved a lot of the challenges for us," says Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md.

What Is A Hedge Fund?

A hedge fund is simply a re-creation of the proprietary trading desk you'd find at any major Wall Street house, Lee explains. The operation is typically housed in a limited partnership or limited liability company that gives the general partner (manager) a broad investment mandate and rewards him with a handsome percentage of the profits. Frequent trading, concentrated portfolios and leverage are common. Hedge funds are private securities that investors must qualify to purchase. Investment minimums can be six or seven figures.

At least 15 or 20 different types of strategies exist among hedge funds. The absolute-return seekers are dubbed non-directional. They pursue opportunities unrelated to what the market as a whole is doing. Directional strategies, meanwhile, take exposure to market trends such as changes in exchange rates or commodity prices. A fund of funds helps an investor diversify hedging strategies by investing in other hedge funds of the manager's choosing. By investing in a single fund of funds, the client only has to meet one investment minimum, and this is just one among other benefits.

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