Want exposure to hedge funds without investing directly in one? Need access to the alternative asset class while at the same time preserving capital? The answer may be a structured product, a semi-exotic investment instrument in which a derivative facilitates exposure to a basket of funds or an index.

In some cases, the instrument is a financial contract. In others, it is a note. In Europe, where structured products are perceived as a good way for retail investors to access alternative investments, these vehicles have become very popular. They are starting to get attention in the U.S., although for different reasons.

Part of the appeal of structured products is that they can offer protection against downside risk. For instance, with a structured note, the investor recoups his principal at maturity, plus hedge funds returns, if any. Because these instruments are hard to design, however, the guarantee often comes at a cost. To counter that, banks that structure those derivatives often use leverage or options to enhance returns.

It looks complicated and risky, but in reality, these products are merely expensive and conservative. For the risk-adverse investor, structured products may be a viable alternative to investing directly in hedge funds.

There are several ways to gain access. Two emerged last week.

The first one came from hedge fund manager HFR Asset Management, which announced a new partnership with J.P. Morgan ( JPM ) to offer structured products pegged to HFR's platform of managed accounts. HFR is similar to a fund of funds, but the platform is structured in a trust format. Instead of investing in hedge funds, the investors have separate accounts with each manager. Assets remain under the custody of the trust, which gives investors much more liquidity and transparency than if they had invested in a traditional fund of funds. Through the partnership, J.P. Morgan will help its clients choose a basket of managers from the managed account platform, and the bank will issue structured products linked to the selected basket. The investor will buy into the basket indirectly via a structured product. This approach is considered to be active management, as the client designs his own portfolio.

The other scenario is the "passive" version. RBC Capital Markets announced last week that it has created a new investable index of hedge funds, comprising 250 managers. The bank plans on offering structured products linked to its new index. The investor gets exposure to a hedge fund index for the same reason a mutual fund investor would switch to an ETF. The idea is to buy the market instead of selectively picking the managers (or the stocks in the case of an ETF.)

Getting Crowded

You might think that the breakneck pace of mergers and acquisitions in 2006 would be manna for arbitrage funds that specialize in corporate takeovers. But the returns don't show it, and veterans in the space attribute the problem to overpopulation.

"There are a lot deals and it spreads out the number of people trying to get into each deal," says Russell Lundeberg, chief investment officer of Barrett Capital Management, a Midlothian, Va.-based multifamily office that is bullish on the strategy. For the first two months of the year, merger arbitrage posted a 4.40% return vs. 3.80% for all strategies combined, according to the HFRI Fund Weighted Composite Index.

"We're seeing a tsunami of money back into the field," says a former merger arbitrage hedge fund manager who reconverted into special situations. Says Tom Burnett, director of research at Wall Street Access: "Look at all those merger arbitrage start-up hedge funds. With the Internet, you can set up this thing in a closet."

Merger arbitragers are happy today with a 6% return, while in 2000, they wanted 8% to 10%, Burnett adds.

Tabled

Sometimes, hedge fund lobbying pays off, especially in Connecticut, which is effectively the industry's home state. A draft of a bill in the Connecticut Legislature would have required hedge funds that are based in the state to disclose their holdings. The proposal didn't play well with the Managed Funds Association, the largest hedge fund trade group. At a hearing of the state's joint banks committee, the MFA voiced its opposition. The original bill was killed and replaced by text that simply calls for the establishment of an antifraud unit. Nobody really objected to that.

The fraud unit will be small, with a $250,000 annual budget and two employees. State Rep. John Stripp, the sponsor, says that he backed away from his original bill because hedge funds had explained to him that "disclosure would create a lot of problems. There would be issues around proprietary information and the risk of copycats creating disruptions in the market." What else is new?

On the subject of secrets, Phil Goldstein, the hedge fund activist who bravely sued the Securities and Exchange Commission last year over its requirement that funds be registered, is getting ready for another battle. Goldstein is targeting 13Fs, the SEC filing that requires managers of larger hedge funds to disclose their holdings.

"That 13F information is confidential," Goldstein says. "It's a trade secret. Like the formula of Coca-Cola." Some people view Goldstein as an eccentric. No one else has challenged the agency on the registration rule. But some have begun to take his SEC lawsuit more seriously after a U.S. appeals court judge appeared to side with him. A decision is still pending.

Carried Back

One recurring theme among hedge funds is the unwinding of the yen carry trade. Hedge funds used to borrow yen at an interest rate near zero, exchange it for dollars and invest the proceeds in higher-yielding assets such as U.S. Treasuries, commodities or emerging markets. But with Japan taking steps to tighten its monetary policy, the cost of borrowing in Japan is no longer nothing, and hedge funds can't go on playing the same game.

The attractiveness of the trade diminishes dramatically," says one fund manager. "People unwind the trade. They liquidate portions of their portfolio. It could create a cascading effect on a lot of hedge funds."

Recent weakness in some emerging markets and commodities is already being attributed to the phenomenon.