Slowly but surely the mutual fund masses from Main Street are mixing with the hedge fund set on Wall Street.

Hedge funds were once reserved for well-heeled investors looking for alternative investments wherein they could safely pass on their wealth to the next generation. Staggeringly high minimum requirements and exotic-sounding investment strategies kept the average retail investor on the outside looking in.

That's changed over the past few years. The mutual fund industry has gradually been rolling out new offerings that use sophisticated hedge fund strategies, but are tailored to meet the needs of the growing number of savvy retail investors. Simultaneously, the number of hedge funds in the U.S. has mushroomed to an estimated 6,800 with about $860 billion under management, leading to a greater awareness of the once reclusive and exclusive investment vehicle.

"Investors have matured," says Jonathan Ferrell, portfolio manager for the

(TOPFX)

Rock Canyon Top Flight fund. "More mutual fund investors understand hedge funds and the techniques they use now."

Dan Culloton, analyst at Morningstar, says he has seen more mutual funds employ hedge fund strategies in recent years as a means to appease both investors and portfolio managers.

"From an investor perspective, the bear market made market neutral strategies appealing," says Culloton, referring to a strategy where a fund goes long and short in the same sector or industry. "And on the other side, the fund companies were facing a talent retention issue. Their top managers were leaving to start hedge funds. By branching out into new hedge fund styled mutual funds, it keeps the managers home and the clients happy."

But just because retail investors finally have access to the same strategies favored by their wealthy neighbors does not necessarily mean it is without risk.

Hedge Funds vs. Mutual Funds

Like mutual funds, hedge funds pool investors' money and invest it in financial instruments in an effort to make a positive return. But unlike mutual funds, hedge funds are not registered with the

Securities and Exchange Commission

This means that hedge funds are subject to very few regulatory controls. In addition, many hedge fund managers are not required to register with the SEC and therefore are not subject to regular SEC oversight -- although that could soon change under new agency rules being considered.

Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative practices like short-selling that typically increase the risk of investment loss. Mutual funds, on the other hand, have traditionally been long-only vehicles designed for retail investors less inclined to pursue sophisticated financial strategies.

The final major difference between the two is fees. Hedge funds typically charge an asset management fee of 1% to 2% of the assets, plus a "performance fee" of 20% of a hedge fund's profit. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating larger returns. Meanwhile, mutual fund investors don't have to forfeit a portion of their gains even to the most successful manager and the average domestic equity mutual fund carries an expense ratio in the 1% to 3% range.

Bridging The Gap

With regulatory, strategy and fee disparities so wide, it's unsurprising that each side has been hesitant to bridge the gap. But mutual fund managers like Lee Schultheis of the

(ALPHX)

Alpha Hedged Strategies Fund say that retail demand for products that do not have a strong risk exposure to the direction of interest rates or equity markets is creating opportunities for both sides.

Schultheis' tiny $17 million no-load mutual fund allocates assets among a group of specialized hedge fund managers that employ long/short equity hedging techniques including convertible bond, merger and fixed income arbitrage. In order to meet regulatory approval, Schultheis does not invest directly in hedge funds like a hedge fund of funds. Instead, he has sub-advisors manage funds according to their style in separate accounts.

A basic hypothetical example of a long/short strategy would be if a manager buys shares of

Coca Cola

(KO) - Get Report

and shorts shares of

Pepsi

(PBG)

. The result is that the market risk is offset because extraneous factors like rising interest rates and energy costs would hit both companies equally. Nevertheless, managerial risk increases because the manager better be correct in his choice of cola company stocks.

The Alpha Hedged Strategies Fund was introduced in September 2002 and is one of the few that utilizes assorted alternative investing styles. The more typical fund in this category sticks to a single strategy, which is another reason why Schultheis sees growth ahead.

"A number of single style funds like the

(ARBFX) - Get Report

Arbitrage Fund,

(CVSIX) - Get Report

Calamos Market Neutral Fund and the

(MERFX) - Get Report

Merger Fund have closed due to lack of capacity," says Schultheis. "That means there's a strong demand out there for a new type of product."

The Arbitrage Fund and the Merger Fund employ a hedge fund strategy called "merger arbitrage," whereby a manager simultaneously buys the stock of a company being acquired and sells short the stock of the company doing the acquiring. Merger arbitrageurs look at the risk of the deal not closing on time or at all. Because of this slight uncertainty, the target company's stock will typically sell at a discount to the price that the combined company has when the merger is closed, thus creating a so-called risk less profit.

That's not to say mutual fund companies will start stocking the shelves with new hedge fund products to feed the retail masses. The regulatory and operational headaches of marrying mutual and hedge funds still remain unattractive to many potential managers, which is why there are less than 20 funds that use hedge fund tactics.

And there is still the issue of educating the Main Street investor about what it means to use some of Wall Street's fanciest financial tricks. Rock Canyon Top Flight's Ferrell, for example, directs his $18 million long/short fund towards "sophisticated investors looking to fill out a larger investment program. And only in a tax-advantaged account."

And Ferrell's dead serious about the tax-advantaged account warning. Stocks in his fund turn over nearly every two weeks compared to the Morningstar average of a little over once a year.

But Ferrell says he has been managing money in this style since 1998 -- this particular fund started in December 2002 -- and that "people who have taken the time to understand our strategy in the past have done well with us." In 2003 the fund was up 53%, but year-to-date it's down 4.5%, so it's definitely not for the faint of heart. Furthermore, trading costs of up to 8% on top of its expense ratio of 2.5% also weigh on its performance.

A mutual fund that uses a long/short strategy with far less turnover is the

(NEEGX) - Get Report

Needham Growth Fund which was started in May 2002. This fund only turns over about half its shares over the course of a year and caps out its short positions at 25% of the fund, leaving it with a bias towards the long side.

The fund has been guided by a new management team for just over a year now, which has made Morningstar analyst Todd Trubey cautious on the fund until the new managers -- let alone new investors -- grow comfortable with a somewhat "racy strategy."

"They need time to prove themselves," says Trubey. "It's like a great chef left the kitchen. Now they need to make sure they are producing the same quality dishes."