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The recent blowup of the Bayou hedge fund has again brought the dark side of hedge fund investing into the forefront. As an advisor, I love the ability of hedge funds to deliver absolute returns regardless of market direction but I worry about giving client's money to someone and then trusting that it will not be mis-appropriated or lost in aggressive investment strategies. I believe a better way to get the benefits of hedge funds without some of the drawbacks is to invest in mutual funds that follow hedge fund like strategies.

Hedge funds can be a viable part of any investment strategy. For the most part, they seek to generate absolute returns regardless of market direction and they tend to be non-correlated with traditional stocks and bonds. The downsides are that you have to be an accredited investor to invest in them (earn $200,000 a year or have $1 million in assets), they are illiquid, there is little, if any , disclosure on the underlying investments, and fees can be steep with most funds charging a management fee plus a percentage of profits.

Hedge fund of funds are another popular investment alternative. With these funds a manager is hired to create a diversified portfolio of hedge funds. Investors still have to be accredited and there are still some of the drawbacks to hedge fund investing.

Until recently there were no real alternatives for non-accredited investors or people who didn't like some of the hedge fund drawbacks. In 1997 the short rule, which made it very difficult for mutual funds to sell stocks short, was repealed. Then the market collapsed in 2000, leaving investors looking for mutual funds that could beat zero instead of beating the market. Since then a confluence of mutual funds have been introduced that follow hedge fund strategies: Long/Short, Merger Arbitrage, Commodity, Tactical & Strategic Asset Allocation, Hedged Equity, Global Macroeconomic, Market Neutral, etc.

Unlike private hedge funds, mutual funds publish their holdings on a regular basis, have daily liquidity, cannot charge performance fees, don't have nearly the same potential for fraud, and cannot use unlimited leverage. The disadvantages of using mutual funds are that there are currently a limited number of options, many of which are closed to new investors, a lack of a long term track record for many, and many of the best and brightest managers only operate private hedge funds.

I believe that for many investors mutual funds that follow hedge fund strategies are a better alternative than hedge funds or hedge fund of funds. Added to a traditional portfolio they can provide absolute return and diversification benefits. Investors can also use them to create their own fund of funds and create portfolios that have shown good performance with low risk in the past.