When we think of traditional asset classes, we think in terms of stocks, bonds, cash and perhaps, real estate. You might think that covers the spectrum, but that view would discount the role of hedge funds, which are defined as “alternative” investments.

The idea behind these increasingly popular funds is to earn a positive return throughout all market cycles. The effect, essentially, is to straddle the fence: going long with one part of the portfolio and going short with another. The strategy seeks to profit from the “dispersion” between the two.

This seems like a perfect strategy. In fact, it has passed muster with many institutional portfolio managers. Pension funds, for example, have been using alternative strategies as an asset class for the past 10 years — albeit as a diversification tool first, and only secondarily as a performance enhancer. In the best-case scenario, hedge funds can reduce portfolio risk and enhance portfolio return, which effectively generates positive alpha.

In the past few years, individual “accredited” investors have been able to access a broad range of alternative strategies through hedge funds. Unfortunately, those same investors tend to buy hedge funds because of the potential return. Usually, they give very little thought to how these assets fit within a portfolio.

What some investors fail to recognize is that hedge funds come with their own set of rules, like manager compensation and leverage. These are factors that do not typically play a role in other asset classes.

Leverage is a serious issue because it makes the hedge fund susceptible to large hits should the dispersion effect move against the manager.

In fact, if you look closely at why most hedge funds fail, it rarely has to do with the investment strategy. Instead, it often has almost everything to do with excess use of leverage. So, knowing that, where do hedge funds fit in modern-day portfolio management?

To get there, we first need to understand how professional managers manage. Here is a look at the three different approaches:

> Modern Portfolio Theory. This is the classic approach to portfolio management. MPT was introduced by Prof. Harry S. Markowitz in 1952. The basic idea behind MPT is to construct an efficient portfolio for each client, which essentially means achieving the inves-tor’s required rate of return with as little risk as possible.

The distinction for MPT is that the risk we are talking about is total risk, which includes both market risk and the risk that is specific to each individual security in the portfolio.

It comes down to risk-adjusted returns, in which some of the stocks in the portfolio will go up while some will go down. You make money if more go up than go down.

> Capital Asset Pricing Model. CAPM is credited to Prof. William F. Sharpe, who first suggested the strategy in 1964. Central to CAPM theory is that you don’t need to be exposed to total risk to achieve efficient returns.

The theory is that all stock-specific risk can be diversified away until all you have is market risk exposure. Investing in a broadly based market index will give you the most diversification possible — that is, no stock-specific risk.

So, what drives the returns in a CAPM portfolio? The thinking here is that as the market rises, it will pull all of the stocks in the index up with it, just as a rising tide lifts all boats. If a CAPM portfolio manager believes that the market will go down and, therefore, pull the portfolio down, he or she transfers money out of the market and into cash or treasury bills.

> The Hedge Fund Approach. Obviously, hedge funds don’t fit either model. If we look at the MPT approach as the “market risk plus stock-specific risk” approach and the CAPM approach as the “market risk only” approach, then what’s left? The hedge fund strategy, which is the “stock-specific risk only” approach.

Some hedge funds isolate and embrace stock-specific risk by trying to eliminate market risk. The idea is to buy individual stocks while shorting the overall market in certain proportions.

This strategy has been expanded to include long stocks, short sectors and even long in some stocks while short in others in the same sector.

@page_break@A recent example would have been subprime arbitrage. That involved going long in financial stocks with low exposure to the subprime market, such as Gold-man Sachs Group Inc.; while going short in companies with high exposure, such as Bear Stearns Cos. Inc., Merrill Lynch & Co. Inc. or Citigroup Inc.

Key to the success of any of these strategies is that the stocks that are purchased must be undervalued securities. Which is to say: portfolio managers focus on the analytical ability to separate the good stocks from the vagaries of the overall market.

That also tends to be the marketing story that hedge fund companies use to promote their strategies. But from a portfolio perspective, we should be thinking about the diversification effect that hedge funds bring to the overall portfolio.

The diversification effect is driven by the fact that hedge funds function on a dispersion matrix, as opposed to other asset classes, which operate on a directional matrix.

From a portfolio perspective — and that is the only perspective clients should use — the hedge fund should always be viewed as a diversifier first and a performance enhancer second.

This means that if you and your client buy into the concept, buy a hedge fund that holds a basket of hedge funds employing different strategies. You may not get a major performance bump, but the basket will provide diversification. And that is the real value proposition. IE