The age-old dilemma of the money manager is how to get returns on capital when your area of expertise isn’t providing those returns. This is one reason why hedge fund managers developed the multistrategy fund.

Traditionally, most hedge fund managers would either leave their client’s money in the bank – earning a paltry 1% on their capital – or chase high-risk, low-reward trades in the hope of picking up some returns.

In contrast to these approaches, a multistrategy fund portfolio manager will allocate capital among a series of broadly connected sectors: convertible arbitrage, distressed debt, risk arbitrage, credit arbitrage, and statistical arbitrage strategies. But unlike an index mutual fund – which has to replicate a broader market average – the hedge fund manager can allocate as much or as little capital to each sector as necessary.

It’s a strategy that has done all right this year – the Credit Suisse First Boston/Tremont multistrategy index is up 3.4% this year – compared to a drop of 4.08% for the blue-chip laden Dow Jones industrial average. More importantly, since multistrategy funds are essentially the sum of numerous strategic parts – the two largest of which are convertible- and risk-arbitrage – they are outperforming convertible- and risk arbitrage specific funds, which are up 0.48% and 1.43%, respectively, this year.

The benefits of a multisector strategy is that a manager can stay heavily invested in a hot area – currently credit arbitrage or distressed investing – without having to allocate capital to less rewarding areas. From the investor’s perspective, it can prevent what is known as “correlation risk,” whereby an investor, with allocations to numerous strategies in a variety of sectors, essentially replicates the annual return of the DJIA or S &P 500 indexes.

For the investor, correlation risk is not just a question of average returns. Investing with five or six different hedge funds, each taking a 1%-2% management fee, will consume up to 12% of the investor’s capital prior to return-sharing arrangements.

One of the risks of a multistrategy fund is that hedge fund managers will become overly focused on momentum, focusing on short-term trades, or as is the case this year, emphasizing only one or two sectors at the expense of sectors that take months at a time to pan out.

For example, the CSFB/Tremont index is up 8.47% this year, but much of that return has been concentrated within a few months, leading many managers to conclude that the distressed sector was having an average year.