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Alpha Strategies offers to give retail investors a shot at snazzy hedge-fund-style techniques. But then there is the troubling link Alpha's backers have to the collapsed Beacon Hill hedge funds. Plus Alpha's high fees and underperformance

The big hedge fund story of the moment: accusations from crusading New York State Attorney General Eliot Spitzer that the hedgies are ripping off investors in mutual funds via secret trading arrangements with operators of the mutual funds. If anything, the scandal makes you want to invest in hedge funds, to get in on the illicit gains.

The untold story: Hedge funds are rotten investments, too. A good example of why you shouldn't have anything to do with them comes from Alpha Strategies I, a crossover product of sorts that is like a mutual fund in its mass-market appeal but like a hedge fund with its exotic strategies and high fees.

Hedge funds and mutual funds are both investment pools. They differ in three important respects. Hedge funds have limited exit privileges, with redemption often permitted only once a quarter or once a year; they have outlandish fees, generally in the form of an incentive fee whereby the operator gets 20% of your gains but chips in nothing for losses; and they have looser disclosure requirements from the Securities & Exchange Commission.

Then take a look at Alpha, a year-old investment offering that is registered with the SEC as a mutual fund but uses hedge-fund-like techniques such as selling short, trading derivatives and arbitraging bonds. Alpha now has $12 million of assets. Unlike hedge funds, which tend to have steep minimums ($1 million or more), Alpha welcomes the middle class. You can get in with $25,000, or less if you invest through a brokerage like Schwab.

But do you want to invest in Alpha? Not if you have any brains.

Start with Alpha's murky disclosures, all too reminiscent of hedge funds. A New York-based outfit called Asset Alliance, which is the largest owner (50%) of the money management company running Alpha (Alternative Investment Partners), also had the largest stake (50%, as well) in Beacon Hill Asset Management. Beacon was responsible for the biggest debacle in hedge fund history outside of the 1998 Long-Term Capital Management meltdown. Beacon ran hedge funds that were liquidated this year after huge losses on interest-rate bets that went bad in 2002 and is the subject of a probe into whether it defrauded investors by puffing up its performance numbers. The connection between Asset Alliance and Beacon Hill is not disclosed to Alpha's investors.

Run by two fund veterans, Lee W. Schultheis and Steven R. Samson, Alpha claims that Asset Alliance--which also has three of the five board seats on Alpha's parent--has no operational role with the mutual fund. Hence, who cares about its past? Asset Alliance, in turn, insists that it had no management function in woebegone Beacon Hill, either, and knew nothing about Beacon's purported shenanigans.

In fact, Asset Alliance contends that it, too, was defrauded by Beacon Hill managers, who were allegedly overeager to meet performance milestones that would bring them $26 million in yearly bonuses (and lose them $7 million, recouped from the previous bonus, if the target was missed).

"We do not run the managers we buy stakes in any more than Vanguard runs General Motors," says Asset Alliance's attorney, Richard Prins. Asset Alliance, which also has stakes in 14 other hedge fund operators, originally invested in Beacon Hill in 1998, acquiring its 50% ownership for $40 million.

But Beacon Hill, based in Summit, N.J., portrays Asset Alliance as more involved and in no position to profess ignorance about the hedge group's inner workings. And a lawsuit by Beacon investors contends that Asset Alliance saw daily reports from Beacon about the hedge fund's positions. Asset Alliance's Prins denies this, saying it lacked the right to see such records.

"Asset Alliance's ?risk management team' never complained about those strategies until losses were listed by Beacon Hill," argues Kevin Marino, attorney for Beacon Hill's lead manager.

Beacon Hill says it didn't know its assets were deteriorating and reported that baleful fact as soon as it found out. If Beacon Hill managers were actually up to no good, lawyer Marino declares, then they could have waited out the storm instead of coming clean about the losses and harming their lush bonus income.

Although Beacon's investors didn't know it yet, the hedge operator made the fateful rate wager in mid-2002. According to the SEC, two Beacon Hill investment pools (Bristol and Safe Harbor), both dealing in mortgage-backed securities, understated massive losses from bets that interest rates would rise. Without telling investors, Beacon's managers shorted Treasurys. They were $2 short in government bonds for every $1 they'd invested in the mortgage-backeds. But rates sank to historic lows and the portfolios tanked.

Yet throughout that summer Beacon Hill's customers, who paid at least $1 million to get into Bristol and Safe Harbor, were led to believe that the funds were performing well. According to the SEC, Beacon Hill told its investors that as of August 2002 the Bristol and Safe Harbor hedge funds were both up by 9.5% in the calendar year to date, with a combined $732 million under management.

Two months later Beacon Hill's clearing broker, Bear Stearns, stated in its annual credit review that the two funds had assets worth only $257 million. A week later Beacon contacted its investors and said that Bristol and Safe Harbor had each lost a lesser amount, 25% of their value.

After the SEC questioned this, Beacon Hill told its investors that the losses were more on the order of 54% and that a portion of those losses had occurred prior to the end of August. The SEC puts the total losses at around $417 million.

A new money manager has stepped in to liquidate the two investment pools, and investors are awaiting word on what fraction of their money they will retrieve. After an SEC move last November to oust them, the Beacon Hill management team--led by John D. Barry, a former Prudential Securities and Citicorp financial manager--stepped down.

Complicating the picture are two lawsuits seeking recovery of assets, one by the SEC. The second, by Beacon Hill investors, has named part-owner Asset Alliance as an accomplice in the alleged fraud. In an arbitration case, meanwhile, Asset Alliance seeks $500 million in damages against Beacon Hill Asset Management, Barry and its three other principals.

Let's get back to Asset Alliance's latest investment, in Alpha Strategies. Like the hedge funds it is mimicking, Alpha has turned in subpar returns lately. The Hennessee Hedge Fund Index was up 10.2% this year through July, the latest figures available. The S&P 500 had risen 12.5% by July's end. Alpha, despite all its razzle-dazzle techniques, has meanwhile managed to eke out a meager 0.4% (net of fees) increase for 2003 to date. Over the long term Alpha comanager Schultheis argues that the fund's "market-neutral" strategy will bring 90% of the S&P 500's return with only a fifth of the risk.

The main reason not to own Alpha, though, is not its past performance but its steep fees, 4% of assets annually. The average mutual fund charges 1.5%. Then there is the matter of liquidity. The open-end Alpha can for the moment be redeemed at its full $9.80-a-share net asset value. But the operators can invest up to 15% of the assets in private companies, although Alpha hasn't done that to date. What happens if there's a mass redemption? Comanager Schultheis says there's nothing to worry about. If he does invest in a private firm, U.S. Bancorp will do the annual valuations, he says.

All of this means that retail investors don't have to worry about losing money with Alpha, à la Beacon Hill. Right?