or decades, the high minimum investment requirements made hedge funds a virtually closed, exclusive club, reserved largely for the well-heeled, high net worth investor.

This asset class in itself also carried an air of exclusivity because they tended to employ some of the brightest minds in finance. There was also a perception that high net worth investors tended to be more astute, although in reality, especially given the inherent lack of transparency of this asset class, most only had a rudimentary understanding of these complicated investment structures.

This investment pool however helped promulgate the hedge fund?s prestige because their longer-term outlook allowed managers to operate without too much fear of a run on their investment capital in the emergence of a market down turn.

For many years, these financial wizards produced spectacular returns, albeit in a less efficient market environment. There were also of course a few spectacular failures.

Like many things, all of this changed with the collapse of the bubble economy. The downward adjustment of expected long-term returns from more traditional asset classes significantly increased the allure of hedge funds. Their mantra of high absolute, low beta returns, not to mention the diversification aspects hedge funds offered, suddenly caught the imagination of small investors and professional wealth managers alike. This helped spawn a seemingly endless supply of investment capital. Hedge funds as an asset class had quickly moved out of the shadows on to centre stage.

This triggered an exodus of entrepreneurs from the large financial institutions on Wall Street and London, who were eager to strike out on their own and play to this growing audience of investors.

The application of the fund of funds vehicle not only pooled talent and broadened diversification, but also significantly lowered the minimum investment requirements.

This increased access to the asset class even further and the money simply poured in. According to Chicago based Hedge Fund Research group, assets invested in hedge funds increased from $488B in 2000, to $890B by the end of September of this year. In a recent study on the industry by CitiGroup, it was estimated that there are now 7000 hedge funds in operation today, double that of 1999.

The space afforded in this column does not allow us to go into the many hedge fund investment strategies, except to say that most of them have been around for years. The three aspects investors should be cognizant of before investing in any hedge fund vehicle are topics of discussion in themselves, but for our purposes, we will address these in broad terms. Our main focus will be on the fund of funds approach, because it gives the easiest inroad into the asset class.

The first issue for consideration is of course transparency or disclosure risk. Despite onshore funds in the United States now having to register with the Securities and Exchange Commission by February 1st 2006, regulating the hedge fund industry has proved difficult, partly because of their very nature.

The relative lack of proper and full disclosure compared to more traditional asset classes is therefore still a significant risk when in investing in hedge funds.

Most people are surprised to learn that the failure rate amongst hedge funds is around 15 percent each year. Fraudulent investment schemes have also been on the increase and the large influx of new hedge funds alone should raise enough questions about the level of talent vying for investors? money.

For the fund of funds investor, the selection process and risk management is therefore critical. Smaller, niche players have a role, but they may be for the more sophisticated investors. The rule of the jungle is that larger institutions not only have better access to the top managers on the basis of their investing power, but also have the deeper infrastructures to manage this risk.

The second aspect worth considering, are the high fees hedge funds charge, which are typically 2 percent a year plus a 20 percent take on the profits.

The first step here is to ensure that there is an alignment of interests. In other words, make sure you are not simply paying away fees for lacklustre performance. One way to protect your self is to ensure the fund has certain high water marks before some of these fees kick in.

For the fund of funds investor, one needs to understand that there is a second layer of fees being paid to the under lying managers. This increases the importance of the due diligence required in selecting the right fund of hedge funds.

This point can be brought home with the final consideration investors should make before investing in hedge funds ? performance. From a fund of funds perspective, the longer and more verifiable the fund?s track record, obviously the better, but investors need to understand that the area of hedge fund returns in its self is fraught with pit falls.

The subject of hedge fund index returns is currently the subject of much debate amongst academics, who claim they are not only unreliable and but also quite biased. There is little debate however that overall hedge fund returns have been in decline. According to an index of funds tracked by Hedge Fund Research, returns to the end of September were up a mere +3.60%. Be that as it may, the most important aspect in terms of our discussion are the risk adjusted returns for hedge fund investments, which compared to more traditional asset classes, still come out on top. But even on this basis, returns have declined in recent years.

There are a number of reasons for this, some of which are not going to go away anytime soon. For example, market volatility has fallen to its lowest levels since 1996, which has led to a decline in trading opportunities.

At the same time, fewer investment banking deals, together with changes in the very nature of the way mergers and acquisitions are now executed, has put a strangle hold on strategies employed by merger arbitrage funds. All of this of course is compounded by the fact that there are now also more managers chasing the same returns.

The CitiGroup study estimates that the average annual returns for hedge funds will likely decline further below its historical average and remain there for the foreseeable future.

The data tracking investment flows into hedge funds is still wildly inconsistent, so it is still difficult to tell if the allure of this asset class is finally in decline. It seems more likely that demand for hedge funds has levelled off more than anything else. Hedge funds as an asset class are definitely here to stay, but investors viewing them as a panacea to the declines in returns of stocks and bonds may be sorely disappointed.

They may also be doing themselves a big disservice with an excessively large allocation to hedge funds in their investment portfolio. Alternative investment strategies, like hedge funds, should be used to compliment the overall risk profile of your investment portfolio, not supplement it.

@EDITRULE:

Kees van Beelen is a portfolio manager at the Bank of Bermuda, a wholly owned subsidiary of HSBC. The views expressed here are his and not necessarily the bank?s.