Hedge funds had a good year in 2009. According to the Hedge Fund Research, the HFRI Fund Weighted Composite Index was up 20.04 percent for the year. The top-performing categories had very strong returns with several categories returning over 40 percent. Only two of the two dozen-plus HFRI indexes showed losses for the year.

Given those results, it’s not surprising that hedge funds are expanding their investor-base by making their strategies available through mutual funds for retail investors. According to a recent Wall Street Journal article (“Hedge Fund AQR Goes ‘Mom & Pop’” by Eleanor Laise, January 6, 2006, p. C1), AQR Capital Management LLC, an early adopter of the mutual fund model, just rolled out AQR Managed Futures Strategy Fund, only one week after rolling out a global-stock mutual fund.

AQR isn’t the only firm jumping on the hedge-mutual fund bandwagon, though. Legg Mason Partners and Turner Investment Partners launched funds in the spring, and Laise reports that 26 long-short hedge-mutual funds opened in 2009, pulling in $8.7 billion through November.

It’s easy to understand the funds’ appeal: they provide smaller investors access to strategies that historically have added diversification to traditional stock and bond portfolios and offer, in theory, at least, downside protection.

Rick Kahler, CFP, ChFC with Kahler Financial Group in Rapid City, S.D. started using these mutual funds around 1997. In 1998 he was appointed to a five-year term on the South Dakota Investment Council, an experience that expanded his knowledge and use of alternative strategies to include convertible and merger arbitrage. More recently he’s added managed futures.

Kahler recommends an advisor become very comfortable with the underlying strategies of each of the funds before implementing them in a client’s portfolio. “They are not your plain vanilla asset classes, obviously,” he notes. “An advisor needs to fully understand the inherent benefits and weaknesses of each strategy.”

Nonetheless, some advisors remain leery of the alternative-strategy funds. David S. Morgan, a principal with JMG Financial Group Ltd. in Oak Brook, Ill., shared the following comments:

“Our firm has been using hedge funds in our practice since 1999. We have evaluated a number of hedge fund style mutual funds and ETFs and have chosen not to use them. Although we have not closed the door on using these products in the future, there are several reasons that we remain skeptical about them:

-oLiquidity – Because hedge funds often invest in illiquid strategies, it is important for them to manage outflows requested by investors. The mutual fund structure makes managing liquidity even more difficult for a hedge fund. A typical hedge fund requires advance notice for withdrawals by investors, and only offers withdrawals on a quarterly or annual basis. Mutual funds generally must offer daily liquidity. To deal with the liquidity issue, the mutual fund will likely invest in fewer illiquid strategies and potentially handicap returns compared to a traditional hedge fund structure.

-oAccess to quality management – Mutual funds must maintain a high level of transparency to meet valuation requirements. Some hedge fund managers are unwilling to provide that level of transparency. As a result, the universe of talent is thinner for mutual funds.

-o Historical performance – When we compare the hedge fund style mutual funds to the more traditional hedge funds we use, performance has consistently lagged and, generally, the mutual funds have had a higher level of correlation to the broader equity markets. Alpha Hedged Strategies (ALPHX) and Calamos Market Neutral (CMNIX) are examples. Others, like Absolute Strategies (ASFIX) still have relatively short history.

Timothy C. Utecht, CFA with Life Planning Partners Inc. in Jacksonville, Fla., cites similar concerns. “We have avoided long-short funds for the following reasons,” he says:

1) Expenses – category average is a 2% expense ratio

2) Track record – only a dozen funds have been around more than ten years

3) Performance – only 2 funds have beaten Vanguard Wellesley Income (VWINX – a conservative allocation fund, around 38% equity) over the past 5 years

4) Not a true asset class – long/short relies on manager skill for success, not inherent return.