Throw out the words "hedge fund" to the average person on the street and they'll throw back words like "risky," "volatile," and "dangerous." And it's not hard to see why. The only time these things make news is when they tank and lose billions for their investors.

One U.S. fund, Amaranth Advisors LLC, managed to lose $6 billion US of its $9.5 billion US portfolio in the space of just a couple of weeks in September 2006 by betting wrong on the direction of volatile natural gas prices. The managers thought they'd go up. Instead, they slid to multi-year lows. Oops.

That disaster reminded many market-watchers of the 1998 scandal involving another hedge fund — Long-Term Capital Management LP. LTCM lost its billions by taking leverage to unheard of dimensions — at one point, it controlled $125 billion US of assets with only $4.8 billion US in equity capital. When Russia devalued the ruble in August 1998 and a worldwide "flight to quality" ensued, LTCM's portfolio took a hit it could not recover from. It barely escaped having to default.

Most hedge funds, of course, don't collapse like the previous two. By some estimates, there are now more than 8,000 of these funds around the world, with more than $1 trillion US in invested capital — an amount that's growing by about 20 per cent a year.

Hedge funds are part of the amorphous group known as "alternative investments." In general, hedge funds are private investment pools which are often set up as limited partnerships that share a number of characteristics:

• They can use borrowed money (leverage) to enhance returns.
• They can use complex trading strategies like short selling and arbitrage.
• They tend to have short-term investment horizons.
• They require large minimum investments.
• They expect their managers to make money regardless of overall market direction.

Some hedge funds, in fact, don't use "hedging" techniques at all. In other words, they don't try to offset the risk in one investment by purchasing another that will move in the opposite direction.

Contrary to popular belief, most hedge funds don't make huge bets on a single stock or commodity, for instance. But that doesn't mean that they don't have risks.

Hedge fund managers can employ a variety of investment styles as they try to make money in every type of market. Risk and returns can vary widely. Some funds invest in the stock or bonds of financially troubled companies. Some funds invest in high-yield ("junk") bonds. Some managers use global macro strategies to try to make money off the spread between interest rates in two countries.

Many funds use long-short equity strategies — combining investments that are expected to rise in value with the short selling of those are expected to lose value.

In the case of equity market-neutral strategies, a manager may buy $1 million of stock on one company in a certain sector and sell short $1 million of stock in a different company in the same sector.

Other funds use various arbitrage strategies. These funds can, for example, try to take advantage of pricing discrepancies between two similar securities in different markets, or between two companies involved in a merger.

Some funds use a single strategy and a single manager; some use multiple managers (often called "fund-of-funds"); some employ several strategies and several managers.

On the surface, hedge funds may look a lot like mutual funds. But there are huge differences. A mutual fund manager will be considered a genius if he or she loses 10 per cent if their market benchmark loses 20 per cent. The manager of a hedge fund that did that might lose their job. Hedge fund managers are supposed to make money in all markets. And to do that, they have tools at their disposal that mutual fund managers don't have.

For one thing, hedge funds can buy complicated financial instruments (like derivatives) and they can sell stocks short. Most mutual funds aren't allowed to do that. Most hedge funds can use leverage to increase returns (or magnify losses); mutual funds cannot.

Mutual funds typically are sold by prospectus and have a low minimum investment requirement. Hedge funds are typically sold through a private offering and require a minimum investment from individuals of at least $150,000 or require investors to be worth at least $1 million.

Investors in mutual funds can sell their units at the end of each trading day. Holders of hedge funds often require investors to tie up their money for a year at the start. Many funds then require 90 days notice before an investor can sell and can run into liquidity difficulties if everyone wants to sell at the same time.

Hedge fund managers often don't disclose their holdings to investors or spell out how much risk they're willing to take; mutual fund managers typically have high disclosure requirements.

Finally, mutual funds available in Canada are registered for sale in Canada; hedge funds are often run from offshore havens.

When equity markets are stagnant and interest rates are low, many wealthy investors search for alternatives. Some opt for income trusts or real estate. Some choose hedge funds.

As a group, hedge funds often outperform traditional market benchmarks over time, and do it with less volatility.

Many hedge funds, in fact, are bought by pension funds and other institutional investors as a diversification strategy because their performance often has little correlation with the market as a whole.

But when things turn sour, the losses can be swift and brutal. And because they operate with minimal regulatory oversight, some people think they deserve a lot more attention.