Feeling left out of Wall Street's recent embrace of hedge funds? Take heart: A number of mutual funds use equally sophisticated strategies that may even be better than the real thing -- at least for the average investor.

Hedge funds were once reserved for well-heeled types looking for help in passing their wealth on to the next generation. Staggeringly high minimum requirements and exotic-sounding investment strategies kept retail investors on the outside looking in.

That has changed over the past few years, though. The mutual fund industry has gradually been rolling out new offerings that use intricate hedge fund strategies -- more on these below -- yet are tailored to meet the needs of the savvier retail set. Simultaneously, the number of hedge funds in the U.S. has mushroomed to an estimated 8,000 with about $1 trillion under management, leading to a greater awareness of the once-exclusive investment vehicle.

The explosion in hedge funds has also spawned talk of a "bubble." The danger that these funds could be in for a beating is why investors might want, at the very least, to test-drive mutual funds with hedged strategies before jumping into the real thing. Mutual funds, after all, can provide greater transparency and substantial liquidity at a much lower cost.

Hedge Funds vs. Mutual Funds

Like mutual funds, hedge funds pool investors' money and put it to work in financial instruments. But unlike mutual funds, hedge funds don't have to register with the

Securities and Exchange Commission

. This means that hedge funds are subject to very few regulatory controls, for now. Hedge fund managers won't be subject to regular SEC oversight until next February, when they will have to register as investment advisers.

"The rules under which mutual funds operate are clear and designed to safeguard investors," says Morningstar analyst Todd Trubey, scoring a point in favor of mutual funds. "Legal recourse is more of an option for mutual fundholders should something go wrong."

For investors worried about a so-called hedge fund bubble, that greater oversight can be reassuring, especially since hedge funds are well-known for their secrecy. And while there are redemption fees in most mutual funds, there are no lengthy lock-up periods as there are in many hedge funds. That freedom can come in handy in case of a problem.

In terms of style, many hedge funds seek to profit in all kinds of markets by using additional leverage and other speculative practices, like short-selling. These typically increase the risk of investment loss. Mutual funds, however, have traditionally been long-only vehicles designed for those uninclined to pursue sophisticated financial strategies.

Another major difference lies in fees. Hedge funds typically charge a hefty 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. On the contrary, mutual fund investors don't have to forfeit a portion of their gains even to the most successful manager. Meanwhile the average domestic equity mutual fund carries an expense ratio in the 1% to 3% range.

Finally, hedge funds typically require their investors to be accredited. Accredited investors are deemed by the SEC to be financially savvy enough to invest in hedge funds because they earn $200,000 a year or have more than $1 million in assets.

"An awful lot of younger investors are sophisticated about investing but may not be accredited and want access to hedge funds," says Jonathan Ferrell, portfolio manager for the $15 million

(TOPFX)

Rock Canyon Top Flight fund, which employs hedge fund-style strategies. "Mutual funds with hedge fund properties offer that access."

Bridging the Gap

With the 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 are less exposed to changes in interest rates or equity markets is creating opportunities for both sides.

Schultheis' $69 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 doesn't invest directly in hedge funds like a hedge fund of funds. Instead, he has subadvisers 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

(PEP) - Get Report

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

Alpha Hedged Strategies fund had a banner year in 2004, finishing first in Morningstar's conservative allocation category out of 367 funds with a return of 17.23%. That's more than 6 points ahead of the

S&P 500

.

On the issue of a potential hedge fund "bubble," Schultheis points out that most bubbles occur when too many players are making directional bets that an asset's price will rise or fall. He believes nondirectional strategies like the ones used in his fund pose far less danger.

"A run-up in hedged investing like we are seeing now just leads to lackluster returns because too many people are piling into the same space, thereby squeezing out the returns," says Schultheis.

While Schultheis uses a variety of hedging strategies in his fund, the recently reopened

(ARBFX) - Get Report

Arbitrage fund and the

(MERFX) - Get Report

Merger fund, which is closed to new investors, employ a single hedge fund strategy called "merger arbitrage." In that concept, 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 riskless profit.

Just because awareness about hedge funds is growing among retail investors, mutual fund companies will most assuredly not 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 fewer than 20 funds that use hedge fund tactics.

"From a managerial standpoint, hedge funds are easier," says Ferrell, who also runs a $5 million hedge fund along with the Rock Canyon Top Flight fund. "There's less compliance, less oversight and less reporting, all three of which take away from the goal of managing money and trying to earn investors a profit." In 2004, Ferrell's hedge fund was up 28%, while his mutual fund was up 13%.

From a mutual fund investor's perspective, however, those additional managerial headaches can afford a great deal of comfort for those interested in seeing how the big boys invest.