Illustration: Jack Black

The following story appears in the June 25, 2012 Investment Guide issue of Forbes magazine.

Lawyer Edward Siedle makes a tidy living off of alternative investments—by picking through the portfolios of disgruntled institutional investors to uncover how their stabs at diversification turned out so wrong. Now he’s got some advice for individuals thinking of following Yale, Harvard and the local pension fund into hedge funds, private equity and other alternatives.

“The first thing to ask yourself is, ‘Do I really have the sophistication to understand what’s going on here?’’’ says Siedle, a former Securities & Exchange Commission lawyer and current contributor to Forbes.com who runs Benchmark Financial Services out of Ocean Ridge, Fla.

There’s no doubt individual investors and their financial advisors are falling in love with alternatives. Natixis Global Asset Management recently surveyed U.S. financial advisors and found that nearly half placed alternatives in portfolios of clients with as little as $300,000 in investable assets. The goal of such diversification is to achieve the same or better returns than stocks but with lower volatility.

The reality? As Siedle suggests, alternatives are tricky to find and understand. That means most investors rely on private banks, brokers or other financial pros as intermediaries, raising the risk they will be steered into products that generate tons of fees for the advisors and not much for the investor. Some private equity funds pay middlemen bringing in investors’ dollars upfront commissions of 1% or more, plus a piece of both the funds’ management fees—2% of assets—and their “performance” fees equaling 20% or more of any profits.

Those layers of fees add up. One of Siedle’s clients hired JPMorgan Chase to manage a portfolio of less than $50 million for a modest 0.28% of assets a year. But after adding up the fees embedded in the hedge funds and alternatives the bank put the client into, Siedle estimates JPMorgan’s cut was more than four times that.

One JPMorgan fund of funds in the client’s portfolio held 100 individual hedge funds and charged 2.85% of assets in annual management fees—triple those in the managed mutual funds FORBES typically recommends. Siedle figures that fund of funds has to earn 12% simply to deliver a return to the investor equal to the risk-free rate on Treasurys—a high hurdle.

JPMorgan confirms the annual management fee but notes that most of it flows to individual hedge fund managers, not the bank. A bank spokesperson adds: “The bank believes that even on an after-fee basis, hedge funds serve an important role in portfolio construction.”

Another drawback of private funds: You often must commit your money for eight to ten years or even longer. “People need to understand before they invest in the next shiny object how they will feel about it in ten years,” says Jennifer Cooper, who reviews alternative investments for pension funds as a managing director of Diligence Review Corp. Don’t commit funds you’ll need soon; when Harvard tried to get out of private equity funds in the depths of the financial crisis, it found it would have to take a haircut of 40% to 60%.

Exacerbating this problem, says Cooper, is that investors tend to hand money to once successful managers just as those managers are entering a long period of well-paid mediocrity.