Call it the retailization of hedge funds. Once limited to investors who could afford to plunk down upwards of $1 million, hedge funds–those private investment pools that employ a variety ofsophisticated (and sometimes risky) techniques in an attempt to make money in both up and down markets–are increasingly being pitched to regular Joes like you and me. Okay, maybe not regular Joes inthe sense that you’ll find hedge fund managers hawking their wares at Wal-Mart. But the doors to these private funds are now being opened to investors who have not millions but tens of thousands toinvest.

Last fall, for example, a division of Deutsche Bank launched the DB Hedge Strategies Fund, which, for a minimum investment of $50,000, spreads your money among 20 to 30 hedge funds selected by the fund’s adviser. In June, Rydex Capital Partners also took the “fund of funds” approach with its new Rydex Sphinx Fund, except that the fund will invest in the 40 hedge funds that make up Standard & Poor’s Hedge Fund Index. Price of admission? $25,000.

But just because you can get access to hedge funds, does that mean that you should jump into them?

To be sure, hedge funds have long attracted top investing talent like the legendary George Soros and Julian Robertson. But there have also been periodic blowups; one of the more recent involves the alleged mispricing of assets that led Lipper Holdings, a hedge fund run by former New York City deputy mayor Ken Lipper, to write down the value of its assets by some 40%. (Mindful of such incidents, the Securities and Exchange Commission has been investigating hedge funds for the past year and held a two-day public roundtable in May to discuss whether they need stricter regulation.) Safety aside, there’s the matter of fees, which, to put it mildly, tend toward the blimpish side.

So before you start salivating at the thought of investing with the big boys, let’s take a closer look at hedge funds. Do the managers deserve their vaunted reputations? Are they worth their fees? And most important, should investors be flocking to them in the expectation of superior returns?

BEHIND THE NUMBERS

At first glance, there appears to be little doubt that you can get superior results from a hedge fund almost regardless of market conditions. For the one, three, five and 10 years through April 30, for example, hedge funds easily outperformed U.S. diversified mutual funds, not to mention Standard & Poor’s 500-stock index, according to the Hennessee Hedge Fund Index. Those returns came with relatively low volatility, suggesting that hedge funds can help you achieve the investing equivalent of nirvana: high gains with low risk.

But the reality isn’t as clear-cut as the statistics seem to be. For one thing, while people talk about hedge funds as if they’re a specific type of investment, the term is really a description of investment vehicles that can employ an extraordinarily wide variety of investing strategies. For example, some hedge funds, known as macro funds, aim to capitalize on major international trends or events, such as a declining U.S. dollar or interest-rate movements, while others specialize in distressed securities. Some hedge funds use leverage–that is, borrowed money or derivatives–in an attempt to amplify returns. Still others sell stocks or entire stock indexes short in an effort to profit when markets are headed south.

So when you look at the broad index returns reported by hedge fund databases and consulting firms, what you’re getting is a snapshot of an incredibly diverse range of investing styles or strategies that can have dramatically different levels of expected returns and risk. The result: The broad hedge fund indexes don’t give you much insight into how specific managers are doing or, for that matter, how a particular type of fund might be expected to perform. So basing your expectation of performance on a broad hedge fund index makes about as much sense as using appreciation rates on homes nationwide as a gauge of the health of the housing market in your neighborhood–which is to say, not much sense at all.

You might figure that you could get a much clearer sense of hedge fund performance by narrowing your scope to funds that follow a particular investing style, much as you would home in on the returns of, say, large-cap value or small-cap growth mutual fund managers as opposed to all equity funds. And in fact, the various purveyors of hedge fund returns slice and dice their main indexes into dozens or more subindexes that are designed to track specific strategies. MSCI, for example, breaks down its main index into a staggering 160 different strategies.

But even this approach has a big shortcoming. For example, two hedge funds can both practice convertible arbitrage–that is, they attempt to exploit differences between the price of a company’s stock and its convertible bonds–yet end up with wildly different returns and risk levels because one focuses on the volatile tech sector or tries to juice its returns by borrowing much more heavily than the other.

Even within specific styles and strategies, says Leola Ross, a research analyst at Frank Russell Co., “the kinds of things hedge funds do are so diverse that you’re just not going to find the consistency among managers that you do in other types of investments.” The variation in hedge fund performance within the same style can be so broad that Ross says style and strategy categories tend to be poor indicators of the behavior of individual funds.

THE PRICE IS RIGHT?

There’s also a question of just how much you can count on the performance figures that hedge funds report. One major issue involves hedge funds’ pricing of their securities. Many managers, particularly those who own distressed securities and convertible and mortgage-backed bonds, often buy investments that trade infrequently (or “by appointment,” as investment wags put it). That can make it devilishly difficult to attach an accurate value to those holdings–and in some cases can even lead to “creative” pricing that inflates the value of the holdings and overstates a fund’s returns. A recent study of 100 hedge fund failures over the past 20 years by financial services consulting firm Capco found that more than 20% of those failures were due to reports or valuations with false or misleading information.

But even in less dramatic cases, illiquid holdings can have what researchers refer to as a “smoothing effect” on returns. Since the prices assigned to hard-to-value securities are often mere estimates of their market value, they tend not to reflect the ups and downs of actual trading prices. The result, according to a March working paper on hedge fund returns by three M.I.T. researchers, is that for “portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, which will understate volatility and increase risk- adjusted performance.” Translation: The promise of high returns with low risk that’s central to the hedge fund mystique may sometimes be more illusion than reality.

SUPERIORITY COMPLEX

Harry Kat, a professor of risk management at City University’s Cass Business School in London, goes even further. He claims that traditional methods of calculating risk-adjusted performance are inherently flawed in a way that exaggerates the investing prowess of hedge fund managers. The reason: what researchers call “negative skewness and kurtosis.” That may sound like a combination of bad posture and liver disease, but it actually means that hedge funds carry the risk of occasional catastrophic losses. As a result, says Kat, traditional risk-adjusted performance stats based on hedge funds’ average returns don’t properly account for all the risks that investors are assuming.

Kat says that a better way to measure the investing skill of a hedge fund manager is to duplicate the fund’s returns by trading a portfolio of Standard & Poor’s 500 stocks and cash, and then compare the cost of that trading strategy with the cost of investing in the hedge fund. This tells you whether hedge fund managers add value by achieving their returns at a lower cost. When Kat applied this analysis to 77 hedge funds and 13 hedge fund indexes, using returns for the 10 years through April 2000, he found that the vast majority of managers did not pass that test. Concludes Kat: “There’s really nothing special about the returns hedge funds generate. It’s just that most investors misinterpret them.”

TO HEDGE OR NOT TO HEDGE?

That’s not to say, of course, that of the 6,000 or so hedge funds doing business, there aren’t some, even many, that are capable of producing splendid returns even after adjusting properly for risk. But identifying them is another matter. For one thing, the bewildering variety and sheer complexity of strategies that hedge fund managers employ make hedge funds much more difficult to evaluate than mutual funds. I think of it as the difference between understanding arithmetic and understanding advanced calculus. Of course, if you get into hedge funds through a mutual fund “fund of hedge funds,” the mutual fund’s adviser can do the heavy lifting when it comes to selecting the hedge funds themselves.

But even if the adviser chooses wisely, the extra layer of fees in a fund of funds can take a big bite out of returns. (See “Fee for All” on page 64.) How big? Let’s say you invest in the DB Hedge Strategies Fund, which charges an annual fee of 2.2%. And let’s assume the hedge funds in the fund’s portfolio have a typical “one and 20” fee structure–that is, a 1% annual management fee plus 20% of profits. If the hedge funds have a gross return of 10%, they would first deduct 1% as a management fee and then siphon off 20% of the remaining 9%. That would leave a return of 7.2%, from which DB Hedge Strategies would lop off its 2.2%, leaving you with 5%, or half the gross return. Of course, your net return would be higher if the hedge funds earn more. But even a 15% gross return drops to just 9% after fees, and a 20% return falls to 13%.

Bottom line: If you’ve already made the most of the other, far less expensive diversification options out there–bonds, REITs, the entire range of stock fund investing styles–and you can meet the investing minimums and you feel you understand what the hedge fund managers are doing and how it jibes with your other holdings, feel free to give hedge funds a whirl. But if you’re expecting to get unparalleled investing talent or a sure path to lofty returns–or if you see a hedge fund as a sign that you’ve arrived as an investor–there’s not much I can say to stop you anyway.

Senior editor Walter Updegrave is the author of Investing for

the Financially challenged (Warner Books). You can reach him at

investing101@moneymail.com.

Fee-for-all

Hedge funds of funds charge multiple layers of fees that can add

up quickly and dramatically lower the returns that investors

actually receive.

GROSS RETURN 20.0% 10.0%

minus

Hedge fund 1.0% 1.0%

management fee

Hedge fund 3.8% 1.8%

incentive fee

Fund-of-funds 2.2% 2.2%

management fee

equals

NET RETURN 13.0% 5.0%

Notes: Assumes hedge funds charge 1% management fee and 20% of

profits after management fee. Fund-of-funds fee based on annual

charge for DB Hedge Strategies Fund. Fees for other funds may be

higher or lower. Source: MONEY estimates.

www.money.com

To learn more about investing strategies, check out ASK THE

EXPERT, Updegrave’s online column.

For more on the basics, try our MONEY 101 lessons on stocks,

bonds and funds.

Quote: At first glance, hedge funds seem to promise high returns with low volatility