Hedge fund mutual funds create accessibility to an alternative investment formerly off-limits to all but large institutions and the wealthiest investors.

Fri, 03/16/2012 | BY Adriana Reyneri

An expanding breed of mutual funds is making hedge funds, an alternative investment formerly off-limits to all but large institutional investors and the wealthiest of individuals, widely available to retail investors.

A hedge fund is one of numerous alternative products than enable investors to diversify their portfolio away from traditional stock, bond and cash holdings. Diversity is prized for its ability to reduce the volatility of a portfolio by spreading risk across a wide variety of financial products. In a well-diversified portfolio, investments act inversely to each other so that when some go down, others go up.

Hedge funds are privately-held pooled investments that employ a variety of strategies in the quest for high returns. According to Sheyna Steiner, of Bankrate.com. some hedge funds are involved in mergers and acquisitions, others in bankruptcies, others in a long/short strategy of purchasing both winning and losing stocks. Some hedge fund strategies are highly risky, according to Hedge Wrap. but a privately held hedge fund is not subject to the same full disclosure law as a publicly traded fund.

Hedge funds also get a band rap for their high management fees, said Hedge Wrap, but in return, a well-managed hedge fund provides valuable diversification and gains in a down market. The products hold relatively low appeal for individuals with less than $15 million in investable assets, according to a fourth quarter study by Millionaire Corner on the financial products favored by affluent investors.

Eight percent or less of investors below the $15 million threshold choose to invest in hedge funds, but the share soars to 36 percent for those above the $15 million mark. Even these wealthy investors prefer other alternative investments, including Real Estate Investment Trusts or REITs (63 percent), limited partnerships (63 percent), precious metals (55 percent), private equity (51 percent), commodities (44 percent) and venture capital (38 percent) to hedge funds.

Retail investors seeking exposure to hedge fund strategies can pick from a growing menu of alternative mutual funds that use hedge-fund strategies, but the investments call for due diligence.

“Not all of these funds have performed as advertised, however,” warns Mallory Horejs of Morningstar Inc, which tracks the mutual fund industry. “The average long-short fund, for example, lost only 7.4% during the recent drawdown (roughly half the market’s fall), but hasn’t provided positive returns over the past five years. Investors in market-neutral strategies have fared better, with the average fund up 0.5% over the past five years. As with traditional mutual funds, some alternative mutual funds undoubtedly deserve a spot in your portfolio, but not all.”