Being late to the hedge fund game is a good thing. Hedge funds are a classic example of hype not equaling reality. Each week, another hedge fund is exposed for either poor returns or sham investment methods. Hedge funds are virtually unregulated by the SEC. Many have fees in the range of 2 to 6 percent per year.

According to Lipper, approximately 75 percent of professional equity money managers fail to beat the S&P 500 index over time. You have to ask yourself this: If the manager of the fund was unable to succeed in the highly scrutinized world of mutual fund investing, how will he beat the market with all the extra fees? "Survivorship bias" presents another problem in analyzing these investments because the poor returns of failed and closed hedge funds are not included in the pro forma past-performance results of most hedge funds indices.

You would be better off to construct your own hedge fund by diversifying across cash, bonds, stocks, natural resources, closed-end funds and exchange-traded funds.

Jerry Wade, Wade Financial Group, Minneapolis

It’s never too late to invest in a sound long-term strategy, but new entrants and a flood of new money have created a crowded field. Not every manager can provide above average results—and a bad one can lose money fast.

Apply the same common sense to investing in hedge funds as you would to any other investment. Be skeptical of returns that appear too good to be true. Look for a manager with a proven track record—better yet, look for one whose results are audited by a well-known firm. Make sure the team and process responsible for the results are still in place. Be wary of results based solely on seed amounts of capital, as certain strategies are more difficult to execute with larger sums. Also, keep in mind that back-tested results are often worthless.

Most hedge fund blowups in recent memory resulted from a breakdown in systems and risk controls. The funds simply grew too large too quickly. Be particularly skeptical of hypergrowth funds that lack the required investment in people and infrastructure. Consider diversifying your risk by investing in a hedge fund of funds—a fund that invests in other hedge funds.

Leo V. Marzen, Bridgewater Advisors, New York

Due diligence of hedge fund managers requires more time and resources than most individual investors can or wish to devote. Furthermore, research shows that an investor needs 10 to 20 different funds to successfully diversify. Unless you have the capital to build a diversified portfolio of hedge funds (which can be substantial given typical hedge fund minimums), a better approach is to explore hedge funds of funds. While these products contain an additional layer of fees, they can be a convenient way to buy a bundled blend of managers.

When evaluating funds of funds, look for operations that have a long-term track record of success, experienced senior management with low staff turnover, a portfolio of at least a dozen funds allocated to a variety of hedge fund strategies, and fees that are reasonable (under 1.5 percent, including management incentive costs). Another benefit of funds of funds is ongoing monitoring of managers (critical in such a rapidly changing industry), so ensure that the fund has regular dialogues with each underlying manager. Most importantly, look for a product that is not just an aggregator of funds, but one that also builds a thoughtful portfolio considering each fund’s place.

Alice Finn and Kyle Schaffer, Ballentine, Finn & Co., Waltham, Mass.

The addition of alternative investments such as hedge funds to your portfolio should be based on long-term portfolio objectives and tolerance for risk. For affluent investors, hedge funds may be used to enhance returns and/or diversification.

When choosing, be aware that "hedge fund" is a generic term and that hedge fund investment offerings are diverse and cover the entire risk/return spectrum. Some common risk factors to consider include, but are not limited to, limited liability, lack of transparency, leverage, complex tax considerations, potential loss of capital and potential lack of diversification.

Steve Ashworth, Wachovia, Winston-Salem, N.C.