Hedge funds provide critical strategies to hedge against market risks that could benefit every portfolio. From the Gates' and Buffets to the smallest investors, everyone could use a little protection against a market meltdown.

Now some mutual funds use these strategies, too.

How Hedge Funds Differ from Mutual Funds

Aside from minimal regulation and the high minimum investment, hedge funds are similar to mutual funds. It is the strategies they employ that are the main difference.

Hedge fund managers have greater flexibility over their funds' investments. A typical mutual fund manager will be limited by set asset allocations (say, 70% stocks and 30% bonds). A hedge fund's investments, on the other hand, are up to the sole discretion of the manager.

So, let's have a look at the strategies that hedge funds and now some mutual funds -- use.

Hard Assets

Hedge fund managers may sell most of the fund's securities and hold cash (US dollars or Euros, usually) or other assets (commodities). Hard assets shield investors from overexposure to the equity markets.

Short Selling (Shorting)

Shorting is selling stocks that you do not own so that you can buy them back at a discount later. Any investor with a margin account can do this, but few mutual fund managers are entrusted with this high-risk strategy.

If an investor decides that a stock is overvalued -- Let's say XYZ is trading at $7.50 -- the investor shorts 1,000 shares of XYZ at a profit of $7,500 ($7.50 per share X 1,000 shares). She now has an extra $7,500, but must buy back those 1,000 shares of XYZ in the future.

Luckily, a week passes and XYZ releases a negative outlook press release and the stock price drops to $6.50. Our investor calls her broker and "covers" (purchases) 1,000 shares for $6,500, keeping the remaining $1,000 for herself. This is a risky strategy which loses money when the stock rises in value.

Long-Short

Hedge funds typically blend short selling with "long" positions, hence the name long-short. Long-short funds purchase securities that they think will increase in value while shorting securities they think will fall. This hedges

Equity Market Neutral

Equity market neutral is stock-picking within an asset class that hedges against risk using a long-short method within that asset class. A manager may believe that ABC stock is a better health insurance stock than ZZZ. The manager will then buy, or "long," ABC while simultaneously shorting ZZZ.

With this strategy all that matters is the relative performance of these two stocks, regardless of the larger market's performance. If ABC stock rises more than ZZZ (or falls), the investment makes money.

Market Neutral Arbitrage

Arbitrage investing exploits imbalances in pricing between securities.

Market neutral arbitrage seeks out imbalances in securities from the same issuer. This strategy hedges against market risk by investing in opposing positions (long and short) in different asset classes of the same issuer. A manager, then, may short sell a company's stock while simultaneously purchasing the same company's bonds.

Merger Arbitrage

Merger arbitrage focuses on companies involved in a takeover or merger. When Company A announces that it is going to buy Company B for a set price (let's say, $50 per share), Company B's stock will rise to a point just below that of Company A's purchasing price (let's say $48 per share). The difference between the acquiring price ($50) and the stock price of Company B ($48) is called the spread ($2 in our example). The point of merger arbitrage is to turn that spread into short-term profit.

If two companies are merging, the manager purchases shares of the smaller company while shorting the larger until the merger.

The only risk in merger arbitrage is deal risk - the possibility that the merger or acquisition will fall through.

Convertible Arbitrage

A convertible bond is a corporate bond that can be redeemed for company stock at some future point. Like any bond, its price falls if a company's credit rating falls or if interest rates rise. Convertible arbitrage profits from the difference between the price of the bond and the value of the stocks it can be redeemed for.

Fund of Funds

As its name implies, a fund of fund invests in multiple mutual funds or hedge funds. Multiple funds may diversify a single strategy over different asset classes, or they may employ various strategies. Such a fund spreads the investment over multiple hedging strategists.

Use These Strategies Sparingly

In recent years many mutual funds have emerged that use these strategies. Look out for them and invest cautiously. No more than 10% of your portfolio should invest in any of these off-market strategies, but they will provide stable returns even in a down market.