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Advisors weigh pros, cons of hedge funds in portfolios

Should hedge funds still play a role in portfolios? CNBC.com asked several advisors to offer the pros and cons — in their opinion — and found that, while many are lukewarm about hedge funds per se, they still have a strong interest in employing hedged strategies.

Pro: Finding a good hedge fund manager who can consistently provide true portfolio diversification with a relatively straightforward strategy could be a portfolio plus, said certified financial planner Elliot B. Herman, partner and chief investment officer with PRW Wealth Management.

"Many investors might incorrectly perceive hedge funds to be a risky investment to a portfolio," he said. "While some hedge funds do opt to swing for the fences, a good number are designed to be non-correlated to other financial instruments and also limit volatility within their portfolio and inside a diversified portfolio."

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For his part, Joshua Wilson, partner and CIO at WorthPointe Wealth Management, said that "some strategies are more agnostic to the stock or bond markets and may allow an investor to generate a return that is not dependent on traditional markets going up in value."

He added that some strategies offer the opportunity to invest in assets or strategies normally too difficult for individuals to access because of lack of scale, connections or expertise.

According to Igor Tiguy, certified financial planner and director of planning for Twelve Points Wealth Management, a significant pro is improved total and risk-adjusted returns, primarily from lower portfolio drawdowns.

Con: Tiguy listed several downsides to using hedge funds, including cost, illiquidity, lack of transparency, high-minimums, lack of access to "Main Street" investors and a time-consuming paperwork process.

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Herman at PRW Wealth Management said that "unfortunately, many hedge funds have been victims of a rising equity market the last five years that has offered minimal opportunities to take advantage of the hedging techniques intended to mitigate downside risk."

WorthPointe Wealth Management's Wilson said that "almost nothing can [be] stated as being universally true of all hedge funds, [which] can make communicating their value very difficult."

Clients don't understand the great diversity of available strategies and how each one behaves and defines success, he said. And hedge fund benchmarks aren't always very useful, because they lump all strategies together.

"High fees get a bad rap sometimes because investors don't understand value," Wilson added. "Strategies that are more work intensive or require more skill simply couldn't be offered for the same fees than more vanilla strategies.

"While some may be successful at picking the right industry or opportunity, there are many that, in the long run, don't necessarily outperform markets. There is significant risk of loss." -Marianela Collado, senior financial advisor with Tobias Financial Advisors

"When a strategy almost inevitably doesn't produce a return for a short amount of time, some investors believe they are overpaying and may abandon [it] when it is actually producing the most value," he added.

Marianela Collado, CFP and senior financial advisor with Tobias Financial Advisors, said that in the active portfolio management world, hedge funds are sold as investments that are venturing into profitable opportunities. "While some may be successful at picking the right industry or opportunity, there are many that, in the long run, don't necessarily outperform markets," she said. "There is significant risk of loss."

Collado is concerned that internal and external out-of-pocket costs may far outweigh the expected return for investors.

"These hedge funds may not necessarily disclose the internal cost of the funds themselves, but clients often feel the cost of having a more complex tax return to prepare," she said. As a result, many clients require extensions because the tax-reporting forms are not available until just before the extended due date of their return.

Furthermore, Collado said, "some [hedge funds] add additional complexity in the items of income that flow through these investments and require clients to file in many states where these funds are deemed to be doing business."

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Hedgelike alternatives: While the cons may outweigh the pros of hedge funds, advisors still embrace the use of hedged strategies. Tiguy of Twelve Points Wealth Management suggests advisors navigate the liquid-alternative universe of mutual funds, which includes many hedge fundlike strategies, with lower fees, lower minimums, more transparency and liquidity.

"Managed Futures and Global Macro are two of the strategies that translate really well from the traditional hedge fund world to the liquid alternative mutual fund format," he said. "Managed Futures has been especially helpful in providing uncorrelated returns, while protecting the portfolio during large and extended market drawdowns."

Herman of PRW Wealth Management said his firm moved away from hedge funds more than five years ago due to high fees and lack of transparency.

"We prefer using open-ended hedged investment products ... to provide benefits similar to what is expected from private hedge funds," he said. "We like the asset class and recommend being careful to know what you own and why you own it.

"But the downside of this class is that not all strategies are so straightforward or battle-tested — just as in hedge funds."

— By Deborah Nason, special to CNBC.com