Alt funds can offset risks in market -- or add it

— -- If you look at the rankings for the year — or the past five years — you may see funds whose names sound like spare parts for the space station. What are these, and what do they do?

Welcome to the world of alts, short for alternative investments. In theory, they're designed to help you offset some of the risks in the market, using techniques pioneered by the hedge-fund industry. Whether the funds are worth the trouble is another story.

Both Morningstar and Lipper have added new categories to try to sort out the alts. The new types are:

•Volatility. The top-performing fund this year is VelocityShares Daily Inverse VIX ETN. The ETN means it's an exchange traded note — an unsecured debt obligation whose ultimate value is tied to an index. The index, in this case, is the VIX, a measure of the stock market's implied volatility, as measured by the options market. When the VIX rises, the market expects more violent movements — usually tumbles. When the VIX falls, the market expects calmer seas ahead.

This fund rises when the VIX falls — the "inverse" part of the name. You could use the fund if you think the stock market will settle down.

•Bear market. These funds are designed to rise when the stock market falls and vice versa. Many use futures and options to double or even triple a fund's daily rise or fall. Doing so is called using leverage.

Leveraged funds have their own peculiarities, chief among which is that you can invest in a bear fund that rises twice as much as the Standard & Poor's 500 falls on a daily basis and still lose money in a bear market.

The reason: Bear markets usually don't go straight down, and if you own a bear market fund when the market rises, your losses get amplified. The math works against you. If you lose 10%, you need to earn 11% to get even.

•Long-short equity. Betting that a stock will rise is called "going long." Betting that a stock will fall is called "going short." A long-short equity bets on the stocks that it thinks will rise and against the ones it thinks will fall.

In theory, a fund's short bets will help in bull markets — some companies fail in the best of times — as well as help offset the pain in a bear market. As a category, the funds performed reasonably well in 2008, a dreadful bear market year. The average long-short fund fell 15.4%, compared with 38.5% for the S&P 500.

Bear in mind, however, that a long-short fund enables a fund manager to be wrong when he's long and wrong when he's short.

You can also invest in funds that take advantage of moves in currencies and commodities. Typically, however, these are used by sophisticated advisers and active traders. Think carefully before investing.