I probably might start this one out by saying what a hedge fund used to be, when they were originally conceived. Hedge funds first appeared in 1949 in the United States, invented by Alfred Winslow Jones, who was born in Melbourne in 1901. Originally Jones only marketed to sophisticated high net-worth investors, and his returns were nothing short of spectacular, in 1966 the Jones Hedge Fund had outperformed even the best mutual funds by 44 per cent a year over the previous five years, and 87 per cent a year over the previous 10 years. For the two decades that he ran public funds, Jones' average net return to investors exceeded 20 per cent a year. Despite the present hype about them they are hardly new.
A hedge fund used to be a fund that sold short what they considered to be really lousey stocks, and bought what they figured were good stocks. They sought to "hedge" against market movements because in theory if the market drops 20% that should hurt all stocks in the portfolio, good and bad, in equal measure, so the profit on the 10% fall from the short selling would be enough to compensate for the 10% loss on the long holdings.
The idea wasn't to predict the market, in fact the idea was to make overall market direction irrelevant, the idea was to benefit from the difference in performance between really poor quality holdings and really good ones. Jones' fund was just this type of fund, a long/short combination selling overvalued stocks and buying undervalued ones.
This idea of the long-short fund is still around, and many managed funds that you wouldn't normally call a hedge fund do use short selling. As an example, Platinum International Fund short sells stock, in addition to their value approach to buying, in fact they made a killing short selling .com stocks during the Tech Wreck, which is one of the reasons why Platinum did so well against a falling market.
Don't call them a hedge manager though, hell hath no fury like a Platinum portfolio manager who has just been told he runs a hedge fund, I've witnessed this myself during a Platinum presentation. Platinum is one of the more well known examples because they have a joint venture in Australia with MLC, so they are a commonly used fund, for all I know you may have some money invested with Platinum, as MLC is one of Australia's biggest managers. You should note though that MLC made Platinum create a sister fund to the International Fund, the MLC-Platinum Global Fund limits short positions and has to minimise tracking error by sticking to the main part to MSCI index stocks.
Today, many funds that call themselves hedge funds have moved right away from this method of investing. They use all manner of complex derivatives including index futures and more exotic financial futures, options and warrants, stocks, international currency futures and so on. The original concept of a market neutral long-short fund has been so changed by the passage of time that many managers now no longer call themselves hedge funds, using titles like "Absolute Returns Fund" and other such names.