Hedge funds, still more often than not, are portrayed in the media as very risky out-there investments not suitable for anyone, particularly small investors. The message is that only mega-millionaires need apply for membership in this exclusive club, and if by choice or by chance, an invested hedge fund should blow up, the mega wealthy will write it off as the cost of doing business.

In fact, it seems that there is no better way to catch a headline (and thereby fame as a writer) than to discuss the ultra oversize compensation of skilled hedge fund managers coupled with their offshore secretive ways. Sounds like sheer envy to me.

So what is the real truth-in-reality here?

First some history. The hedge fund industry, or more appropriately termed the alternative class industry, is estimated to reach $2 trillion in growth by the end of 2009. The first hedge fund strategy was developed in 1949, a long-short leverage methodology that is still used extensively today. Many well-respected hedge fund managers have 25-year track records with the industry itself now in existence for more than 60 years. Hedge funds crossed the road a long time ago from out-there esoteric virtually impossible to understand investment management with a few large players to virtual mainstream well-defined investment strategies with many and varied participants.

Why are hedge funds different? They operate as investment vehicles that seek risk-adjusted absolute returns, rather than following or trying to outperform an investment benchmark, such as the S&P 500 Index. Some hedge fund managers use strategies that seek to minimise losses in down markets while providing stable return on equity when markets are booming. Others exploit small pricing discrepancies between securities in two different markets, say one in Japan, one in the US in order to make a profit while using leverage to enhance returns. Another successful method that can be fairly long-tailed is working with distressed companies, or buying their bonds at fire sale prices, then realising capital gains when the company regains profitability. In all of these investment environments, the diversity of strategies results in low correlations with a plain vanilla equity market benchmark.

They are not as heavily regulated as mutual funds. Lack of regulation and not having to adhere to a strict investment policy gives hedge fund managers greater flexibility, along with their ability to reduce risk and grow capital in tougher markets.

Hedge funds have their detractors. For a number of years, various government agencies and security regulators on a global basis have expressed concerns about maintaining market stability and integrity, given the market power of large hedge funds, or many hedge funds to increase volatility. With the recent melt-down of what were perceived as the more conservative banking systems, it will be interesting to see whether thinking has changed in defining how (and which) participants had the greater capacity to affect capital market risk. Certainly, one probable outcome is that just about everyone understands what a CDO (collateralised debt obligation) is and how the sub-prime market caused a capital market security daisy-chain reaction. Knowledge is always power, particularly if that knowledge is gained ahead of everyone else.

Hedge funds are now entrenched (and serve a valuable asset diversification component) in even ordinary portfolios, particularly in the offshore world. The US has been extremely slow in lifting some of the scepticism and big brother paternalism when it comes to allowing hedge fund participation by the ordinary investor. Still seeking to protect investors from themselves - yes, we do need that from time-to-time, unfortunately, more from scam and fraud salesmen than legitimate investment managers - alternative class investments are considered mysterious, confusing, and risky to even retail client-focused advisors. In my own profession, I have read articles where supposedly sophisticated planners have stated that hedge funds have no place in a portfolio. This centric view extends to foreign currency and foreign equity as well. Until recently, US-based investment gurus never recommended allocations of more than 10 to 15 percent in foreign stocks while holding other currencies was not even on the radar. I suspect that one ramification of seeing significant global asset appreciation against the dollar, along with Far East and Middle Eastern investment managers, declaring that the dollar is dead, has finally exposed US investors to the capital growth of the rest of the world.

The Yale University Endowment Fund, among many large pension/endowment funds, has been utilising the strength of hedge fund alternative investments for more than 20 years. This approach to investing pioneered by the legendary David Swenson has achieved high double-digit annual returns with low risk and only moderate draw-downs. Mr. Swenson is so respected that his best selling book, "Unconventional Success: A Fundamental Approach to Personal Investment" is often referred to in the industry as "The Book of David".

Super endowment funds like those at Yale and Harvard are trendsetters, but this is an industry that is quick to emulate success, particularly when changes in asset allocation produce consistent higher long-term returns. The secret - in average US endowment funds, the more traditional assets (equities, bonds, and cash) make up 86 percent of the portfolio, but in the super funds, only 48 percent of the portfolio assets are comprised of equities, bonds and cash. Multiple asset classes and additional diversification do make a difference. Source Frontier Capital Management LLP - Investing like Harvard and Yale Endowment Funds - April 2007.

Next article: should you have alternative class funds in your portfolio and what will they do for you?

Martha Harris Myron CPA -NH1929, CFP® -67184 (US licenses) TEP - Society of Trust and Estate Practitioners. She is a senior wealth manager at Argus Financial Ltd., specialising in comprehensive financial solutions and investment advisory services for individual private clients and their families, business owners, endowments and trusts. DirectLine: 294 5709 Confidential email can be directed to mmyron@argusfinancial.bm The article expresses the opinion of the author alone. Under no circumstances is the content of this article to be taken as specific individual investment advice, nor as a recommendation to buy/sell any investment product. The Editor of the Royal Gazette has final right of approval over headlines, content, and length/brevity of article.