Hedge funds may turn out to be a greater competitor to mutual funds than most people expected. While hedge funds are extremely risky vehicles that do not appeal to investors who are interested in safer products, funds of hedge funds offer some of the advantages of hedge funds with an enormous reduction of risk. Although the number of funds of funds is relatively small right now, it's growing, and may soon capture a lot of assets that ordinarily would have gone to mutual funds, say industry observers.

Clearly, mutual fund firms are aware of the increasing popularity of hedge funds. Several companies either increased their presence or entered the hedge fund arena earlier this year through acquisitions, such as OppenheimerFunds, which bought Tremont Advisors, and Legg Mason, which bought Private Capital Management. Hedge funds held a total of $344.5 billion in assets at the end of last year, according to Freeman & Co., and the firm estimates that that number will grow to $915 billion by 2005.

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