A properly diversified portfolio of stocks and bonds can achieve similar, if not better, performance than an average hedge fund of funds (HFOF), a new study finds.

Demystifying Hedge Funds II, a report released this week by Presidio Financial Partners, pit a model diversified portfolio against the HFRI Fund of Funds Composite Index and found that the portfolio generated a higher average annualized return than the Index. The diversified portfolio generated a return of 6.3 percent, compared to 5.2 percent for the HFRI Funds Index over a six-year period from April 2000 to March 2006. An analysis that began in January 1990, the month the HFRI was created, revealed a similar result: the diversified portfolio generated an average return of 10.6 percent compared to 10.1 for the HFRI Fund of Funds.

In a press release, Presidio managing director Jeff Spears said that the report was not trying to dissuade investors from hedge funds, but rather seeking to advocate prudence. “The point is that as hedge funds become more popular, investors need to proceed with caution,” Spears noted. “Finding the top performing funds is exceedingly difficult, but there are hedge funds that are absolutely worth the additional fees and risk.”

To minimize risk, the report recommends avoiding funds that become popular, have low barriers to entry and are easy to execute. It also suggests assembling a diversified pool of hedge fund managers who will look for opportunities in complementary fields and not be exposed to the same risk factors.

The model diversified portfolio used in the study was designed to replicate the typical asset allocation of investors and consisted of the following: 40 percent taxable bonds (Lehman Aggregate Index), 20 percent U.S. large cap (S&P 500), 10 percent high-yield bonds (ML Lynch High Yield Master II), 15 percent international equity (MSCI EAFE), 10 percent U.S. small cap (Russell 2000) and 5 percent emerging market equity (MSCI EMF index). The HFRI Fund of Funds Composite Index is the benchmark of HFOFs.