Designing a separate hedge fund portfolio. A great many investors have built what they think of as separate hedge fund portfolios that are designed to improve their overall returns, but that aren't thought of as playing a particular role in the overall investment portfolio. The trouble with this approach is that, if we don't have an expectation for exactly how the hedge fund portfolio is supposed to behave, how can we know whether it is working for us or not? The notion that it doesn't really matter as long as the hedge fund portfolio is performing well is naive. No hedge fund portfolio, however well designed, will always perform well. Thus the question is always before us: When the hedge fund portfolio isn't performing well, is it still playing a worthwhile role in our overall portfolio? We need to know the answer to this question, but too many investors aren't even asking it.

Using long/short hedge funds as the high-alpha component of an asset class strategy. One of the best uses of hedge funds, especially directional funds, is as the high-alpha portion of an equity strategy. We could decide to index a core position in U.S. equities, then build a satellite position using long/short hedge funds. One difficulty with this strategy is that hedge fund managers tend not to keep doing what they were doing when we hired them, with the result that our overall U.S. equity exposure will tend to behave in quixotic ways.

Using hedge funds of funds. All but the very largest families will likely find that the safest strategy in the hedge fund space is to build a core hedge fund exposure by investing in a hedge fund of funds. Yes, this adds yet another (often substantial) layer of fees to the already burdensome fee structure. But a best-in-class hedge fund of funds will perform at least the following services for investors:

Alas, it is also true that the great majority of hedge funds of funds either can't or don't provide high-quality ongoing monitoring of their managers. Of the more than 1,000 hedge funds of funds available to investors, no more than a few score are worth their fees. It is, in other words, nearly as difficult, though perhaps not as dangerous, to identify best-in-class hedge funds of funds as it is to identify the best individual hedge funds. Intense diligence will be required before engaging such a fund of funds.

Using nondirectional hedge funds. Nondirectional or absolute-return-oriented (ARO) hedge funds exhibit more of the characteristics of a separate asset class, at least when combined into numerous ARO strategies. Typically, then, the best practice with ARO funds is to create a separate allocation to these strategies. A well-balanced group of ARO funds (accessed in the case of most family investors via an ARO hedge fund of funds) should exhibit volatility roughly similar to that of bonds but should generate returns more similar to those of stocks. But don't be fooled by the low volatility. ARO hedge funds pack plenty of risks, even though volatility measures don't necessarily pick up those risks.

Using multistrategy hedge funds. Most individual hedge funds focus on one investment strategy, or perhaps two related strategies. Some funds, however, are so-called multistrategy hedge funds. These funds tend to engage in a variety of strategies, many of them unrelated to each other. The senior professionals overseeing the multistrategy fund will allocate capital among the various strategies depending on where they see value in the marketplace. Thus, if spreads have tightened in the distressed debt markets, the multistrategy fund might reduce the capital employed in that strategy and move it to, say, convertible arbitrage. In a sense, then, multistrategy funds can sometimes stand in for funds of funds, offering strategy diversification within one investment partnership. Investors should keep in mind, however, that executing many different strategies successfully will severely tax all but the very best multistrategy funds—and many of those will be closed or will demand very high minimum investments.

Using tax-efficient strategies. High-taxed short-term capital gains and high fees (especially at the fund of funds level) have led some sophisticated families to rethink hedge fund investing from the bottom up. Rather then viewing hedge funds as an alpha opportunity, these investors have consciously decided to forgo potential alpha in favor of certain tax savings. These strategies involve gaining derivative exposure to a hedge fund index, typically via a structured note whose value is linked directly to the performance of the index. These linked notes should be treated for tax purposes as forward purchase contracts, with all profits deferred and converted to long-term capital gain once the one-year holding period has been met. Linked notes usually have weekly liquidity and can be purchased in lots as small as $50,000. No K-1s or 1099s are issued and the notes are DTC eligible, which means they can be custodied along with the client's other assets. As an extra bonus, investors in the notes need not meet the superqualified investor standards required by many hedge funds and funds of funds. Although this will not be an issue for most family investors themselves (the requirement is $5 million in investable assets), many substantial families will have family foundations that do not meet the $25 million (assets) standard for a qualified purchaser, and hence will be frozen out of many funds. It is important to remember that, as with any structured product, there is counterparty risk: The party selling the structured note—usually a large bank or other financial institution—could possibly go bankrupt before paying us off.