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Is a hedge fund in your future?

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Fund managers and private banks are bringing an increasing number of hedge fund-lite products down to the level of the investing masses, typically in a mutual fund structure. Is a hedge fund in your future, and in your long-term investing future's best interest?

Fidelity Investments' Portfolio Advisory Service, which offers managed accounts to people who invest at least $50,000, entered into an agreement with Blackstone Alternative Asset Management this year giving it exclusive access to Blackstone's Alternative Multi-Manager Fund. The mutual fund launched during the summer and invests in hedge funds offered by 11 advisors covering a variety of alternative investment styles, including equity long short and global macro.

To date, Fidelity Investments has placed $1 billion of its clients' assets into the fund, which has a net expense ratio of 2.4 percent.

What's in it for Fidelity's clients? "Investors are getting institutional access in a common structure that they are familiar with," said Fidelity spokeswoman Nicole Goodnow. "It's really a risk return improvement."

Fidelity has also been allocating a small portion of those clients' money to the Arden Alternative Strategies Fund, launched in 2012. The fund invests in hedge funds that employ a variety of alternative investment strategies, including relative value, event driven, global macro, and equity hedge. It has a net expense ratio of 2.3 percent.

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The numbers don't lie. Alternative mutual funds have seen a big spike this year in asset flows, year-to-date raking in near-$50 billion, according to Lipper. That's double the take for alternative mutual funds in calendar years 2011 and 2012. And that's after another banner year for equities. Some of the flows have gone to alternative credit strategies specifically, and many of these strategies are market neutral mutual funds that have been around for years, rather than the more recent trend to offer true hedge fund manager access to retail investors.

"Hedge funds in a straight-up market won't do well and there aren't that many really smart people who can earn two and twenty, but the question is what you do when you don't have confidence in bond markets and don't want to pour all your money into equities." -Lou Altfest, CEO, Altfest Personal Wealth Management

Financial advisors are split on the trend. Wall Street racking up high fees by offering unnecessary products to less savvy investors isn't an approach that sits well with Wes Moss, chief investment strategist at Capital Investment Advisors, an Atlanta-based investment management firm with $1.5 billion in assets under management.

"I think it's a loser's game, because you can get safe diversification in other ways than loading yourself up with 3 percent annual hurdles before you even break even," he said. "It's a seven-layer dip [of fees]. How is anyone ever going to stay apace with the market itself?"

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Peter Mallouk, president & chief investment officer of Leawood, Kan.-based Creative Planning, which was recently ranked No. 1 in Barron's ranking of the top 100 independent financial advisors and has $6.9 billion under management, has even stronger words.

"Basically I can sum it up as, the investment banks are now bringing the least impressive investments to the masses," he said. In fact, Mallouk doesn't believe hedge funds are good idea for any investors. "An investor should never consider a hedge fund in the first place. They have performed poorly as a group, and the expenses and taxes further erode the chances of any reasonable return," he said.

At a time when the S&P 500 index is returning high double-digits and the hedge fund index can't even get near 10 percent this year, you might think Moss and Mallouk's cynicism would reflect advisors by and large—but it doesn't. As a group representing a vast number of America's retail investing business, advisors do see the benefits of alternative investment products, even for the masses, though with some reservations.

"It's a growing part of the investment world and it warrants at least some allocation," said David Zier, chief executive officer of Convergent Wealth Advisors. "The typical, plain vanilla global asset allocation still works and is a very viable and solid strategy, but as new products come out in between stocks and bonds that adjust for volatility, as long as it's well-researched, it makes sense."

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Nick Denefrio, vice president of asset management at Lenox Advisors, said the academic research supports alternatives as being beneficial to portfolio management, and with the proliferation of liquid mutual fund versions, it's an important approach for any portfolio to trim the volatility of market peaks and troughs.

"This space has always been a little expensive, but in the mutual fund world it is getting a little cheaper," Denefrio said. He also spoke to a hidden reason for the trend: The liquidity shock many high-net-worth investors experienced during the financial crisis when they couldn't exit hedge funds has led to a migration of private banking clients from hedge funds to hedge fund-lite products. That trend has created more of an impetus for investment managers and brokers to sell alternative investments in more liquid structures. "A majority of affluent clients feel that way," he said.

Goodnow notes that the Blackstone product was not designed to beat or even compete with the S&P 500, but to improve risk/return, as well as potentially improve portfolio resilience in down markets." Fidelity's managed clients' portfolios are typically invested 3 percent to 5 percent in alternatives, and then only a portion of that may be invested in the Blackstone fund.

Research officials agree, in theory, with this argument. Josh Charney, alternative investment analyst at Morningstar, said you can't compare hedge funds to S&P performance. "On an absolute basis, hedge funds have not been performing as well as the stock market, but they are not supposed to. By nature, the goal of a hedge fund is to hedge," he said, though he does think there are cheaper market-neutral mutual funds options than the Fidelity offering.

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The average traditional actively managed equity mutual fund has an expense ratio of 1.1 percent, while the average market-neutral mutual fund has an expense ratio of 1.3 percent, according to Lipper. Andrew Clark, mutual fund research analyst at Lipper, said that retail investors and advisors are wise to be skeptical: With active mutual funds unable to beat the index and the bond bull market run ending, asset managers are compelled to focus on alternatives because they will have difficulty gaining assets in traditional investors. However, Clark said that U.S. investors are already willing to pay for less in the case of traditional asset allocation: investors believe in the benefits of adding bonds to a portfolio even though bond returns are unlikely to outperform equity returns over the long-term.

"People used to have money market funds and stocks and that was it. You need to trade away some of the equity premium to get diversified and that is going to cost you something," Clark said.

The market-neutral mutual funds that have been around for five years or more have averaged less than 2 percent a year, according to Lipper, while domestic equity funds from large-cap funds to small-cap funds have returned in the high single digits.

"There isn't a cost from a financial theory standpoint because through diversification you will have a good if not better risk-adjusted return," Clark said, adding that in Europe, retail investors have been using alternative funds for at least a decade.

Paul Heathwood, director of intermediary sales for Robeco Investment Management—which was among the first to introduce a long/short fund in the mutual fund format and has grown it from $5 million in assets three years ago to $1.1 billion in assets today—said it hasn't paid to be hedged in the past four years, but that's ignoring the larger investment context of what will protect an investor when the market goes down. Its retail fund, the Robeco Boston Partners Long/Short Equity Fund, has returned 13 percent over the past three years versus an S&P return of more than 17 percent.

"You may say we are under-performing and charging more money, but we have had 50 percent of the market exposure and garnered 68 percent of the market return," Heathwood said. "The higher fees relative to the lower return profile is a hurdle, but far from an insurmountable one," he added. "Our advisors tend to be converted already."

The first question for U.S. retail investors is whether the alternative allocation will limit downside. "Advisors I talk to say downside protection is worth 20 percent of a portfolio, and that's a lot," Clark said. "But making 20 percent less is something many retail investors are not prepared for." Clark views this as the real challenge to spur adoption of what has been a steady grower in recent years for asset managers, but far from a runaway success.

Lew Altfest, CEO of Altfest Personal Wealth Management, said that for too many fund management companies the trend leads with marketing rather than the true merits of an alternative risk and return profile. But, he added, "hedge funds in a straight-up market won't do well and there aren't that many really smart people who can earn 2 and 20, but the question is, what you do when you don't have confidence in bond markets and don't want to pour all your money into equities?"

Or, in other words, what's the alternative?

—By Leslie Kramer, Special to CNBC.com

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