The hedge fund sector is the fastest-growing part of the financial services industry. And, as a result, there are now as many hedge funds and hedge fund strategies as there are strategies for conventional mutual funds.

The advantage of a hedge fund is its ability to play both sides of the market and, by extension, its ability to act as a diversifier within a broader portfolio.

Having said that, it is important to understand how hedge funds work. Hedge funds have unique features that are not part of traditional mutual funds.

> Performance bonus. Conven-tional mutual funds do not typically pay a performance bonus to the manager, whereas bonuses form a major part of the compensation for hedge fund managers. Most hedge funds follow the “2 & 20” rule: a 2% management fee plus 20% of returns that exceed a predetermined threshold. Generally, this is much higher than fees charged by conventional mutual funds.

> Leverage. Hedge funds employ significant leverage, whereas conventional mutual funds typically don’t — although conventional funds may utilize limited leverage either to enhance returns or, usually, to manage redemptions.

> Going Short. Hedge funds go long and short in their space; conventional mutual funds are typically long-only investments. Conventional mutual funds have, however, been getting approval recently to sell short as part of a strategy to hedge downside risk.

> Track Record. Hedge funds typically promote the manager’s expertise and flaunt the track record. Conventional mutual funds talk about the track record, but with less emphasis.

> Positive Alpha. Both hedge funds and conventional funds strive to promote positive alpha — that is, to earn a return that is greater than one would expect, given the risk being assumed. But conventional mutual fund managers are rewarded for managing risk first and enhancing performance second; hedge fund managers are rewarded for enhancing return first and managing risk second.

Coming full circle, the real question is: how does one use hedge funds within a traditional portfolio, assuming, of course, that a typical portfolio includes asset classes such as cash, income (bonds, preferred shares and income trusts) and equities.

If we look at hedge funds as stand-alone investments, we would be buying them on the basis of their performance. Within a broader portfolio, however, we should look at hedge funds as a risk-reduction tool. When we think of risk reduction, we think about diversification, which we define as “the inclusion of assets that produce positive alpha and have a low correlation or, better yet, a negative correlation to traditional asset classes.”

As hedge funds tend to be both long and short, they typically exhibit low or negative correlation to traditional asset classes. That means they are excellent diversifiers within a broader portfolio.

But that comes with a cost. Hedge funds are sophisticated investments, which means that only certain investors can apply. In On-tario, for example, you have to either demonstrate that you are sophisticated by providing your financial advisor with acceptable cash flow and/or net worth statements or you have to be able to invest a minimum $150,000 in a specific hedge fund.

In recent years, however, mutual fund companies have gotten into the hedge fund game by creating a full-prospectus mutual fund that purchases a basket of hedge funds, exposing the investor to myriad strategies. Presumably, if one of the strategies blows up, it will have only a minimal effect overall on this so-called “fund of funds.”

That said, a fund of funds has additional costs, including the cost of the managers of the individual hedge funds and their performance bonuses, if any, plus the management expense ratio that is earned by the mutual fund company to pick and choose the right hedge fund strategies.

At the end of the exercise, the cost of the fund-of-funds model could be 4% a year or more. That’s expensive if you are simply seeking an optimal diversifier.

Are there alternatives? You could opt for a single hedge fund, eliminating the fund of funds’ fee. But that would also eliminate much of the diversification effect that the fund-of-funds model brings to the table. If you are seeking an optimal diversifier within a broader portfolio, eliminating the fund of funds’ diversification benefits may be penny wise and pound foolish.

@page_break@Another approach is to use sectors that act traditionally as diversifiers. This approach normally would lead one to the commodities sector. But while commodities provide diversification, they don’t tend to add much in the way of performance — just ask anyone who has held gold for the past 20 years.

Another alternative might be a sector that typically acts like a hedge fund — perhaps a sector whose major source of business is to manage risk. Anything come to mind?

If you said “banks,” you earn the $64 prize for seeking out portfolio diversifiers. When you think about a bank, the management is really entrusted with managing the risks associated with the economy. A bank loans money, which in many cases, offers no real upside except for the repayment of the loan. The only thing the bank is interested in is making certain the loan is repaid. If the individual taking, say, a business loan should happen to make many times the cost of the loan, that’s good for the business but does nothing for the bank.

Mind you, that is changing. Today, banks don’t just loan money; they often make private-equity investments in which they actually benefit from the growth of a particular business. But simply changing the character of the bank should not erode the bank’s ability to act as a diversifier any more than it would in the hedge fund industry, which is also adding new techniques and strategies to enhance returns.

Even with the change in the way banks do business, they are probably still giant hedge funds. This means managing the risks associated with the general economy, while providing the performance oomph that an optimal diversifier should.

The proof is in the data. Look at the performance of, say, the FPX balanced index from 2000 to 2003. You can use a benchmark calculator (go to www.croftgroup.com, then click on “benchmarks”) to establish returns for a passive traditional portfolio.

Now, take 20% of your assets and buy a basket of, say, the five major bank stocks and calculate its performance in the same period. If the basket’s performance is different from the performance of the FPX balanced index, then you have found a product with low correlation in a downmarket and performance oomph in an upmarket — just like a good hedge fund. IE