Alternative investment products, including hedge fund of funds, long/short funds, and market-neutral funds are increasingly sprouting up in the marketplace. Mutual fund sponsors are busily launching, in record numbers, private investment vehicles that are being registered as limited liability companies and closed-end management companies.

Most of these new alternative investment vehicles employ more flexible and sophisticated trading techniques than traditional mutual funds. They invest in illiquid private securities or spread their investments across a carefully assembled group of independently managed hedge funds.

Fund sponsors are hoping to tap the population of current and emerging affluent investors who just aren't satisfied with traditional equity mutual fund returns. Amid a stormy stock market, many equity funds are barely eking out positive returns or are just squeaking past the returns of the equity indices to which they benchmark. Other funds haven't seen positive returns since 1999 or 2000.

"Fund companies want to get into the business of investing for the high net worth, but have no direct ties to these investors," said Matt McGinness, senior analyst with Cerulli Associates in Boston.

Consequently, fund sponsors are finding that they can make headway in the high-net-worth market by crafting products that appeal to wealthy investors and can easily be distributed through financial intermediaries. "So they build products that [intermediaries] will offer. It's the only way to get into the game," McGinness said.

Assets in hedge funds alone have ballooned from $38.1 billion in 1990 to $536.9 billion through the end of 2001 -- an increase of 1,280%, according to Hedge Fund Research, Inc., a Chicago-based research and consulting firm that specializes in alternative investments.

New Player Emerges

Dallas-based Undiscovered Managers is the newest fund advisor to break into the alternative investments business. The firm currently manages a nine-fund, no-load family of all sub-advised funds with a collective $420 million under management.

Last summer, Undiscovered Managers, which has built a following by courting predominantly independent financial planners and providing in-depth research and analysis to them, released its own white paper on alternative investments and the semi-affluent investor. At a media briefing held in New York in July, Mark Hurley, Undiscovered Managers' chairman and CEO, announced that his firm was looking for an avenue into the promising alternative investments market, but had not yet decided what tack it would take.

True to his word, on Feb. 27, Undiscovered Managers registered the UM Multi-Strategy Fund. The new offering is a hedge fund of funds that will invest in various outside hedge funds that employ a spectrum of investment strategies and techniques.

Undiscovered Managers has hired New York-based Cadogan Management as the fund's subadviser. Cadogan, which was founded in 1994 and currently manages several hedge funds of its own, will be responsible for selecting and monitoring the independent money managers and independent hedge funds into which the Undiscovered Managers hedge fund of funds will invest. According to the fund's registration, this is the first time Cadogan will serve in this type of sub-advisory role.

Undiscovered Managers' new hedge fund of funds will not invest in any of its own mutual funds, nor will it invest in any securities directly. The exception will be temporary investments that the fund will make in fixed-income securities, money market securities and money market funds in order to maintain liquidity. The fund will also not invest in any of Cadogan's proprietary investment products.

But the new fund does expect to invest in an unspecified number of hedged equity funds, both U.S. and international, including hedged sector funds and funds that are not afraid to assume long/short positions. The fund may also look to hedge funds that invest in initial public offerings, distressed securities, and derivatives. It may also use options and futures and engage in arbitrage strategies and short sales.

Swimming Against the Tide

The Undiscovered Managers fund's mission, of course, is to achieve long-term appreciation coupled with low volatility that is not affected by how the equity markets perform.

That's the exact same driving force behind all of the alternative investment products fund advisors have been launching, McGinness said. "Hedge funds are absolute return vehicles whose returns aren't correlated to the markets the way mutual funds or even separate accounts are tied to an index."

And while many advisors are registering to offer sophisticated alternative investment funds to affluent investors, not all will be successful in making a go of it over the long run, although it is too early to say which firms will snare the largest market share, McGinness said. "Very few asset managers have the background to jump into this arena," he said.

Some advisors have literally bought their way into the alternative investments arena by purchasing or partnering with experienced hedge fund managers. Last year OppenheimerFunds acquired hedge firm Tremont Advisors, Mellon Financial, parent to the Dreyfus Family of Funds, bought an equity interest in hedge fund manager Optima Fund Management, and State Street Global Advisors scooped up RXR Group, a hedge fund manager in New York.

And last week, Phoenix Investment Partners announced it had inked a strategic partnership agreement with LJH Global Investments. LJH will develop and manage hedge funds, while Phoenix will provide the sales and marketing muscle. This is the second firm Phoenix has allied with. Last June, Phoenix forged an alliance with Arden Asset Management to distribute Arden-managed hedge funds.

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