Investors have become increasingly frustrated with this current economic environment and the unpredictability of the stock market. While the argument for attractive valuations might compel one to invest in equities, the downside risk of getting in too soon can be daunting. While everyone knows that timing the market is difficult if not impossible, there are strategies, not so well known, that can be used to participate in the market and still protect the downside.

Usually, those alternative strategies have only been available to qualified and/or accredited investors with minimum investments exceeding $1 million. However, there is an increasing number of mutual funds that use these strategies (the same or similar to those used by hedge funds), and which are available for low minimums and daily liquidity.

SEE: Alternative Assets For Average Investors

Longing the Undervalued, Shorting the Overvalued
In fact, there are so many choices of alternative mutual funds that a quick screen on Morningstar for the alternative category reveals 821 different funds. The most popular of these types of funds are the long/short equity funds, which can implement both long and short ideas in their portfolios. This strategy is largely the easiest to implement and the easiest to understand. Portfolio managers go long those securities they believe are undervalued and can potentially increase in price, while at the same time short selling those securities they feel are overvalued and can potentially decrease in price. It is the exposure to these short positions that may provide downside protection when the market declines.

SEE: Getting To Know Hedge-Like Mutual Funds

But there are other strategies, as well, and each investor should evaluate which strategy works best within their unique well-diversified portfolio of equities and fixed income. The Calamos Market Neutral Income Fund (CVSIX), Robeco Long Short Equity (BPLSX), the Arbitrage I (ARBNX) and the Prudent Bear Fund (BEARX) are particularly noteworthy.

The Calamos Market Neutral Income Fund
This fund implements a long/short strategy using convertible bonds and equities. In 2008, this fund lost 13% while the S&P 500 lost 37%, and YTD as of July 12, 2012, the fund has a return of 3.73%. While it trails the S&P 500 YTD, the downside protection it offers is very attractive.

Robeco Long/Short Equity
This fund uses the basic long/short equity strategy mentioned above. It invests a large portion of assets in smaller names, which makes it a bit more volatile than other long/short funds, but its performance speaks for itself. The five-year return is a whopping 13.8% annualized. In addition, while it did lose 21% in 2008, it recovered by a whopping 82.37% in 2009, and it has a 2012 YTD return of 6.25%, about even with the S&P 500.

Arbitrage I Fund
While this fund uses a long/short equity strategy, it specifically invests in announced mergers and acquisitions by buying the target company and short-selling the acquirer. The strategy is dependent on the successful completion of the announced deals, and it profits from taking advantage of the difference between the share prices of each of those companies and their tendency to become equal at the time of deal closing. When the deal is closed, the position is liquidated and a new merger announcement is sought. If market prices go down before the deal is completed, both stocks will tend to move together, minimizing the impact of the fund's position. Only a catalyst affecting the specific stocks in a deal would adversely affect this type of strategy.

The Prudent Bear Fund
This fund only short-sells stocks. When the market is going up, this fund will underperform, but as part of a well-diversified portfolio, this fund will help smooth out overall returns and will perform very well when the market sells off.

SEE: What To Do When Companies Merge

Any of these funds, or similar alternative strategy funds, should be used as part of an overall strategy to reduce the downside risks inherent in a portfolio consisting only of long investments in equities and fixed income.

The Bottom Line
Because of their defensive strategies, these funds typically will underperform the market when markets are extremely bullish. In this market environment, while the European crisis threatens to derail the already fragile global economy, they serve as good "alternatives" to generate potentially attractive returns, without risking the timing of the market.

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