The hedged equity mutual fund category is down -5.03% vs. down -7.32% for the average equity mutual fund category through September 13, 2011. Despite its lower return, the hedged equity mutual fund remains a tool for many financial advisors to keep their clients' portfolios afloat in a down market.

"Hedged mutual funds will diversify your portfolio and provide protection against downside risk, but they are a challenge because of the higher price of investing in them. Most advisors view them as a light holding, not as a core holding," says Morningstar analyst Ben Alpert, who added that hedged mutual funds are pricier than traditional long-only products because investors receive active management that requires more research.

Hedged mutual funds, also known as long-short equity mutual funds, offer more liquidity and transparency than traditional hedge funds but their returns tend to be lower.

"Returns are uneven because they have different strategies that are going to perform differently in different market conditions," says financial advisor Richard Bregman. "Every one of my clients' portfolios start off with at least one-third of the portfolio in alternative strategies as a hedge against unfavorable occurrences in the market. I use hedged mutual funds to lower or dampen volatility and to provide protection against a down market."

According to Lipper, the top four hedge mutual funds that were Lipper leaders in 2010 include Rydex/SGI alpha opportunity series at 23.5%, JP Morgan US Large Cap Value Plus Fund at 11.82%, Wasatch Long Short Fund at 9.41% and Schwab Hedged Equity Fund at 6.5%.

"The level of risk Lipper leaders took to earn their return was better than their peers. Ryder had a strong return and more risk but each unit of return it earned was greater than the unit of risk it took. That ratio was in their favor," says Jeff Tjornehoj, head of Lipper Americas Research in Colorado.

While traditional hedge funds are only available to accredited investors or a qualified purchaser, hedged mutual funds are more accessible and have a lower minimum investment.

"The hedged mutual fund holds long and short positions simultaneously, which is where the returns come from.  Managers make money in all markets by being long on stocks that are going up and short on stocks going down so that they are making money on both," says Jeff Tjornehoj, head of Lipper Americas Research in Colorado.

Alpert suggests that financial advisors introduce their clients to hedged mutual funds slowly. "Hedged mutual funds tend to underperform in bull markets and outperform in bear markets," he says.

The Schwab Hedged Equity Fund minimum is $100. It invests in stocks that have at least $1 billion in market capitalization. Its sectors include telecom and financials.