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Are Mutual Funds That Hedge Just Hype?

Mutual funds that act like hedge funds may be more marketing than miracles, according to George Feiger, chief executive officer of Contango Capital Advisors, a financial adviser in Berkeley, Calif.

"I think we're in danger of a lot of marketing hype," Feiger said. "There will be a lot of advertising, but these things are not going to make a lot of money."

The reason? Hedge funds got there first, Feiger said. And alternative investments will continue to win the race in innovative investment strategies, until Federal regulations change.

Hedge funds, the low-regulation, high-minimum investment cousins of the mutual fund, have grown considerably and performed well since the beginning of the 2000 bear market. In fact, even as the stock market began to rebound, investors continued to pour assets into alternative investments.

Since 2001, the hedge fund industry has more than doubled, with assets under management swelling from $539 billion to more than $1.1 trillion by the end of 2005, according to data from Hedge Fund Research of Chicago.

So far, investors have not been disappointed. For the five-year period ending Feb. 28, the Hedge Fund Research Index rose 8.58%, compared to the S&P 500, which rose only about 2.4% over that time frame. The problem for the average investor is that, historically, hedge funds have also been considered the domain of the rich. Until recently.

Capitalizing on the cache of offerings to the masses that once was relegated to very few, a spate of mutual fund companies have begun to advertise products that espouse hedge fund-like strategies. Companies such as Allianz Global Investors and Julius Baer have sought shareholder approval to apply hedging techniques to their mutual funds, including short selling. Janus Capital and American Century Funds have introduced new products that in and of themselves apply hedging strategies.

The idea is to win big, with less risk, and most importantly, without having to pony up $1 million.

"When the bond and equity markets are flat, people are looking for the next best thing," said Jeff Tjornehoj, a research analyst with Lipper of New York. "This gives them something to dream about."

But a dream is about all it's worth, according to Feiger.

"The whole thing is advertising. It's, Invest like the rich!' but no one will be investing like the rich," Feiger said.

For one thing, by the time a hot new investment opportunity reaches the masses, it's usually lukewarm, he said.

"Clever ideas implemented quickly will be best for the people who can find them quickly," said Feiger. "The retail investor is always the last to know anything."

Retail investors may also be a little behind when it comes to understanding how real hedge funds work, experts said.

"The features that made hedge funds popular in the first place are difficult for open-end managers to exploit," Tjornehoj said.

First of all, while hedge funds typically solicit large sums of cash from individual investors, they end up being relatively small pools, at times closing after collecting just $70 million, Feiger said. Mutual funds tend to be much larger, often with a billion dollars or more. Taking that kind of money and investing in hundreds of small opportunities is neither efficient nor cost effective, Feiger added.

Right now, the arena that can absorb large amounts of money and still deliver decent returns happens to be large-cap companies, said Feiger, but hedge fund strategies simply don't work as well in long-established blue-chip stocks.

"I just don't think huge volumes of money chasing long/short equity is going to make investors a lot of money," he said.

It may be too early to tell whether mutual funds that act like hedge funds will amass too much money to invest nimbly, said Benjamin Poor, senior analyst with Cerulli Associates of Boston. Right now, the hedge-like mutual fund sector represents only $10.5 billion in a multi-trillion dollar market, and most of these funds have less than $200 million each, he said.

What is certain is that Federal regulations hamstring mutual funds in ways hedge funds are not, experts say.

For example, mutual funds can buy illiquid assets, but only to an extent, whereas hedge funds have no restrictions on how they invest their portfolios. And of course, despite a movement among some hedge funds to voluntarily increase transparency, there is no law requiring hedge funds to disclose their holdings to investors.

Likewise, successful hedge fund managers have a defining investment philosophy, but can change the tactics at any point, while mutual funds must garner shareholder approval before significantly changing their course.

Furthermore, while mutual funds must allow shareholders to cash in at any time, hedge funds, more often than not, have lock-up periods, whereby investors are allowed to opt out after, perhaps, only after a year, and even then very often only with 30-days' notice.