If you produce a 10-year track record of double-digit returns, clients will certainly buy in — often without supporting evidence as to how that return was produced. The problem is that higher than average returns are never generated in a straight line, and rarely are they generated without serious downside in any given year.

Even for hedge fund managers who have been able to generate consistently above-average returns, we find they attract so much new money it becomes impossible to deliver similar results in the future. Note the recent retirement of hedge fund icon Stanley Druckenmiller, who exited the business for exactly that reason.

Despite those shortcomings, we cannot ignore the trend. Investors searching for performance are migrating into hedge funds that purport to deliver enhanced returns. That’s not necessarily a bad thing — if investors employ proper due diligence. But investing without understanding the investment can have tragic consequences.

What makes hedge funds unique is their ability to assume both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market in which the fund manager sees potential, according to Miami-based Magnum Global Investments Ltd.

Unlike traditional mutual fund managers, hedge fund managers tend to earn most of their compensation from a performance bonus. Typically, funds charge “2 & 20,” which means the fund manager earns 2% of the value of the fund plus a performance bonus equal to 20% of any return above a high-water mark.

For example, suppose a hedge fund with a 10% high-water mark returns 20% in a given year. The manager would earn a 2% management fee, plus another 20% of the return above the initial 10% high-water mark. In this example, the manager would earn an additional 2% management fee as his or her share in the portion of the return above 10%.

Despite the compensation issues, hedge fund strategies tend to be lower in risk, historically. That’s because hedge funds are usually long and short at the same time.

This strategy profits if the long side does better than the short side — even when both the long and short positions were rising at the same time. As long as the long position is rising faster, the strategy is profitable.

The real bang for the buck occurs if, say, a long/short sector manager is able to pick a winner and short a loser. For instance, think about the period in which the auto sector was getting a bailout. A hedge fund manager who had bought shares in Ford Motor Co., which received no bailout money, and also sold short shares of General Motors Corp. would have generated serious profits over a short period of time.

Having said that, the concept of lower risk comes with caveats. Most notably, the metrics used to measure risk are tainted by survivor biases, leading some pundits — myself included — to question their reliability.@page_break@The so-called “risk-reduction benefit” that comes from a long/short model is often short-circuited by performance objectives and the bonus pool that is created. What typically drives performance is the use of leverage. Too much leverage can cause even the best of strategies to fail — badly. This leads to survivorship bias. Only successful hedge funds survive, and they become the components used to measure performance and risk within a hedge fund index.

Still, a long/short model is attractive, given the current market environment. In a period in which we have high-frequency traders, funds making large directional bets and technical glitches within electronic exchanges that were never designed to deal adequately with the sell side, volatility reigns supreme.

And although volatility is seen as a metric to quantify risk, it really measures the up-and-down movement of the market. For average investors, only downside volatility matters — and a long/short strategy, by definition, provides a hedge against downside volatility.

Another issue, at which regulators now are taking aim, is the lack of visibility within hedge funds. Hedge fund managers are reluctant to disclose their positions for fear that market participants would then be able to short-circuit a fund manager’s strategy.

We see the downside of visibility in the exchange-trade funds that purport to provide double exposure to an underlying sector or market. The double-exposure ETFs typically use futures contracts as the underlying offset to their strategy. Market-makers know that the underlying futures must constantly be rolled forward, which means that there are trades that must be made daily.

More often than not, market-makers take advantage of this, which causes a discrepancy in the normal cost-of-carry model on which an ETF is based. This leads to scenarios in which neither the double-long or double-short ETFs perform as expected.

The bottom line is that hedge funds are making a comeback. But make no mistake: the problems encountered during the financial crisis have not abated. In fact, more regulation — particularly as it relates to visibility — may actually cause greater problems in the future.

In addition, with more ETFs coming to the market that purport to follow specific hedge fund strategies, average investors have greater access to this sophisticated market.

If hedge funds are employed within the context of a broadly diversified portfolio, that is not necessarily a problem. In fact, if investors limit their hedge fund exposure to no more than 20% of their portfolios, it might even be a benefit.

Unfortunately, average inves-tors don’t think in terms of a portfolio approach. Rather, they typically chase performance metrics instead. However, doing so without understanding how a particular performance number was generated is akin to investing in a vacuum. And that’s never a good thing. IE