As double-digit stock market returns become increasingly distant in investors’ rear-view mirrors, more and more are looking at the potential for fine-tuning their portfolios’ performance with hedge funds and other alternative investments.

Not surprisingly, Iowa individual and institutional investors that have chosen to park a portion of their money in hedge funds have taken a conservative approach to their selection and use, viewing them as downside market protection rather than as speculative investments.

Hedge funds, which use a variety of leveraging methods and speculative investment practices such as short selling, first became popular in the 1960s, but fell out of favor after the bear market in the early 1970s. They became popular again in the 1980s, and in their latest resurgence, the more than 6,000 hedge funds in existence are expected to have more than $1 trillion under management by the end of the year.

According to statistics gathered by The Barclay Group, a Fairfield-based company that tracks more than 4,700 hedge funds and managed futures indexes, hedge funds averaged a 5.45 percent year-to-date total return through August, with returns for funds of hedge funds averaging 3.23 percent for the year.

“When it’s all said and done, investors are chasing returns,” said Sol Waksman, The Barclay Group’s president. “The last three or four months, hedge funds have had very decent returns. Based on past experience, I would expect money to begin flowing into hedge funds, because the market is down and hedge funds are up.”

The funds tend to attract talented money managers who can earn high incentive fees based on the earnings, but their popularity has also encouraged Ponzi-type schemes. Scandals such as last month’s guilty pleas by Bayou Group executives, who duped investors out of $450 million, however, don’t seem to be discouraging the heady pace of investments in hedge funds and the funds of funds that provide additional ways for investors to buy into them.

Within the next four years, the Securities and Exchange Commission estimates that investments in hedge funds by private and public pension funds, universities, foundations and charitable organizations will increase to $300 billion, which experts say could significantly increase the exposure of these institutions to the risk of potential losses. However, institutions such as the Iowa State University Foundation say their hedge fund investments are carefully screened and should actually decrease the impact of a volatile market.

Hedge funds will also see more regulatory scrutiny. Until this year, most hedge fund managers have not been required to register with the SEC, but more will be required to register by Feb. 1 under the Investment Advisers Act passed by Congress in late 2004.

Three years ago, the ISU Foundation began investing in hedge funds, and currently has 10 percent of its portfolio, or about $30 million, in two funds that invest in an array of hedge funds. So far, the funds have performed as expected, said Lisa Eslinger, the foundation’s vice president for finance.

“The goal for this portion of our allocation is really a diversity measure, to stabilize the return over time,” Eslinger said. Because the market has been relatively good during that time, the hedge portion of the portfolio returned an average 5.4 percent annual return in the three-year period ending June 30, she said, compared with 9.4 percent for the overall portfolio.

“We’ve only been in them three years,” she said. “So, knock on wood, we’ve never been in an equity market where we’ve really needed them.”

Rather than invest directly in individual hedge funds, the foundation invests in two funds of hedge funds, Quellos Capital Management and Coast Asset Management. “The goal there is to be as diverse as possible,” Eslinger said.

During the same three-year period, the Iowa Public Employees’ Retirement System has reviewed the possibility of investing in hedge funds several times, but has so far decided against it, said Melinda Prince, an IPERS spokeswoman.

“The key for IPERS in determining that a new investment form is needed will be when it is determined that a specific investment strategy (rather than hedge funds in  general, which cover a very wide range of investment strategies and asset  classes) would enhance the return and/or the risk control in the trust fund’s portfolio,” she said in an e-mailed statement.

Investment advisers have received more inquiries from their clients about hedge fund investments within the past few years.

“I have had clients come to me and say, ‘I’d like to supplement my bond and equity portfolio with some alternative investments,’” said Randy Von Fumetti, a financial planner with MGC Financial in Des Moines. “And research has shown these kinds of alternative investments have little correlation to stocks and bonds, which is a good thing.”

Von Fumetti said he generally recommends hedge fund investments only to clients with $1 million or more in assets to invest, and uses a quantitative model to evaluate the potential risk and return. For some investors, he may recommend as little as a 3 percent allocation, while for others he might recommend as much as a 15 percent stake, depending on their individual situations.

Von Fumetti said he usually recommends a fund of funds approach for a client if it is his or her first foray into hedge fund investments.

“I think it’s a good type of first product to look into,” he said. “It provides diversification in product as well as diversification in the managers themselves.”