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Alternative funds for investors

"People would say, 'I think live hogs are going to be worth more down the road. I'm going to buy a futures contract that trades on an exchange that gives me the right to own live hogs in September.' They are betting that the futures contract will increase in value between now and then," says Patti.

Futures contracts may involve financial instruments, such as currency futures, Treasury bonds, index futures or even bank CDs.

"Managed futures funds take long and short positions in futures contracts in all kinds of asset classes," says Papagiannis.

Managed futures funds are not correlated to the bond or equity markets, so they can perform quite well when the stock or bond market is down.

To reduce their stock market risk, an investor could substitute a small allocation in high-risk equities to a small allocation in a managed futures strategy, Papagiannis says.

About 15 mutual funds currently focus on managed futures, she says.

As an example, Rydex Managed Futures Strategy A fund shows a very different pattern of returns from the general stock market. In 2008, the most perilous year for investors in recent history, the Rydex fund finished the year up 2.9 percent. Contrast that with the S&P 500, which fell 37 percent that year.

Market neutral funds

Like long-short funds, market neutral funds use long and short positions to reduce volatility, but they attempt to reduce that volatility to zero.

"A market neutral fund will also be long-short, but the net exposure to equities, for instance, would be zero or very little positive or negative, to try to keep the exposure as close to zero as possible," Patti says.

Market neutral funds strive to provide small but steady returns in all markets. They should lose less money in market downturns, stabilizing your portfolio. They won't provide growth.

"They have virtually no market risk at all," says Papagiannis. "That is not going to get you a very high return. Sometimes people substitute this kind of fund in their fixed-income portfolio because it has a similar risk profile to bonds -- low volatility and low returns."

According to Morningstar, market neutral funds gained an annualized return of 0.95 percent over five years through April 25 versus 2.66 percent for the S&P 500.

Like other alternative strategy funds, these funds are heavily dependent on manager skill in picking securities, and they're not cheap. According to Papagiannis, the average expense ratio for the alternative funds is 1.98 percent, compared to 1.13 percent for the average domestic large-cap blend fund.

Choosing hedge-like funds

Expenses should be only one of several considerations when it comes to choosing a fund that uses alternative strategies.

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Investors first need to decide how much they may want to allocate to alternative strategies, and then which strategies mitigate risk in their portfolio.

"If you have an equity-heavy portfolio, you probably want to diversify some of that risk into less risky equity-types of investments, and that would be a long-short strategy," Papagiannis says.

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