For more than a decade, the greatest bull run in history produced great returns for many investors without even trying. Indeed, it seemed that no matter what you chose, or how undiversified you were, the stock market and your investments had only one way to go, up, up, up!

That was then and this is now. Market analysts predictions are that equity returns overall for the next few years will only average in the single digits. While no one can really forecast markets, that rather gloomy assessment along with the fact that global investments are increasingly correlated has prompted a renewed interest in alternative strategies, better known as hedge funds.

The word hedge means many things, shrubbery, thickets, obstacles, etc. but the most common connotation stands for hedging your bets. If investments are heavily correlated, they tend to move in the same direction under duress from market volatility or other economic events.

Good portfolio management dictates that the investments within the portfolio are not all mirror images - so to speak - of each other. In simplistic terms, a well managed portfolio will contain allocations that resemble a see-saw, when one group is performing very very well, another group is underperforming, but overall effect is to produce a superior average return that minimises risk as well.

As the seesaw rises and falls, each different investment group allocations has its turn at stardom. Money management is harder today because it is much more difficult to find investments that do not move (correlate) in synchronisation.

So, if hedge funds aren't correlated, why aren't they? We need to go back a bit into history to understand where the methodology came from. Hedging risk (of losing one's investment, or locking in a specific price) has been around since the 17th century when merchants devised a way to protect themselves against unfavourable price changes by using forward contracts.

We won't digress into that area in this article, but forwards, futures, interest rate swaps and other contracts are an incredibly huge global business today, particularly in the foreign currency area.

The term `hedge fund' dates back to 1949 when a reporter for Fortune magazine, Alfred Jones felt investors could derive better returns by hedging, rather than buying and holding equities. He set up a small partnership to prove his investment theory, buying long, short selling and leverage to simultaneously limit market risk and magnify returns.

He felt his method was so superior, he charged a premium incentive management fee of 20% of realised profits, then demonstrated his commitment by ploughing most of his personal savings into the fund. In the sixties, Jones' fund outperformed the top mutual fund by 85% on a cumulative basis, net of all fees.

And wouldn't you know, soon there were hundreds of copycats, many of whom imploded because they did not follow his model of hedging risk, they simply used leverage. The incentive fee practice continues to this day in hedgeworld, whereby managers are highly compensated if the fund performs above expectations.

Today, there are more than 4,000 hedge fund worldwide with assets above 500 billion. There have been incredibly successful hedge fund managers, George Soros and Julian Robertson, as well as some incredible disasters, such as the almost global bankruptcy of the fixed arbitrage firm of Long Term Capital Management.

How does the hedging process work? Hedge fund managers buy undervalued securities and sell short overvalued ones. Many other strategies are also used, long/short equity, equity market neutral, convertible arbitrage, fixed income arbitrage, event driven, risk arbitrage, managed futures, leveraged-buyouts, venture capital, etc. Make no mistake, it is an art to simultaneously hold long positions, short sell and leverage the effect. Good hedge fund managers combine a blend of old fashioned fundamental intense research with intuition. None of this money is run on emotion.

Let's look at the strategy that made Mr. Jones famous. Long/short equity. In the industry, there are sexual overtones here, as the vernacular for this strategy is known as covering your position, and going naked.

Most investors have long-only investment returns; that is, they buy a stock, bond, or mutual fund and hold it. They sell when the market rises (hopefully) and produce a gain. If the market falls, and their stock drops in value, they must wait for better days, or face losses.

Over the long term in rising markets, investing in fundamentally sound companies, the `going long' strategy does work. In a declining market, long/short equity hedge funds can play both sides of the market, by purchasing the undervalued stock and waiting for it to rise in value; then, selling short the overvalued stock - which they do not own and watch it drop in value.

They profit by purchasing the overvalued stock at a lower price and replacing what they borrowed from their broker/dealer. Since the short sold stock was cheaper in the open market, they gain in the difference between the short sale and the later buy. See accompanying chart. What a concept! How can you lose? But you can lose, and those losses can be staggering.

Going long - you own the stock. No matter what the market does, all you can lose is the total value of what you own (unless you margin, but ignore that for this explanation). You have covered your position. Going short - you do not own the stock - you are absolutely naked.

No matter what the direction that stock moves when the market does, you must replace the stock you borrowed by purchasing it back in the open capital market. Your potential loss is unlimited! What happens if you have also leveraged that short sell by doubling, tripling, and quadrupling?

Markets are unpredictable; you could get caught in a short squeeze, having to buyback that stock at a far great value that the original short sell value.

Think this doesn't happen? Astute investing firms are incredibly sophisticated. If they detect a large short sell play, they will intentionally bid up the price of the short sell security to inflict losses on short sellers.

This `play' can be terribly damaging when dealing with a young technology stock where the number of shares outstanding can be quite small, and everyone wants them to replace what they borrowed! Alternative investments can be suitable in small positions for a diversified portfolio for the unsophisticated investor; they can complement the remaining asset allocations and can be return enhancers.

But beware, the hedge world is a largely unregulated industry, there are good hedge fund managers and bad hedge fund managers. Unless you are a very sophisticated investor, or can afford to lose your savings, holding your entire portfolio in a hedge fund is not a good idea. And as with all investments, past performance does not guarantee future results. You should seek advice and guidance from an experienced licensed investment professional who can help you construct a diversified portfolio suitable for your financial profile.

Maybe it should include hedge funds, and maybe it shouldn't. It depends.

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Martha Harris Myron CPA CFPT is a Bermudian, a Certified Financial PlannerT(US license) practitioner and VP and Manager, Personal Financial Services, Bank of Bermuda. She holds a NASD Series 7 license, is a former US tax practitioner, and is the winner 2001 - The Bermudian Magazine - Best of Bermuda Gold Award for Investment Advice. Confidential Email can be directed to marthamyronnorthrock.bm The article expresses the opinion of the author alone, and not necessarily that of Bank of Bermuda. At the date of this article, the author held no hedge fund positions. Under no circumstances is this advice to be taken as a recommendation to buy or sell investment products or as a promotion for financial plans.