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Part II. Hedge Funds vs. Mutual Funds

BLOG, EDUCATION  |  15 Mar 2010

Hedge funds and mutual funds are both investment vehicles that involve a professionally managed portfolio in which investors hope to achieve a positive return. Neither of them are purchased or sold on stock exchanges. Other than that, there are relatively few similarities. Let’s talk about the differences.

Who can invest?

As I discussed in Part I, hedge fund investors almost always must meet the “accredited investor” status, which requires considerable wealth or income. Mutual funds have no such restrictions. Basically, if you can fog a mirror (one of Jon’s pet expressions), you can open a mutual fund account.

How much do you have to invest?

Many hedge funds require an initial investment of up to $1,000,000. However as the hedge fund industry has matured several funds have lowered the requirement to a mere $100,000. On the other hand, many mutual funds will welcome you as an investor with as little as $1,000.00, or even less if you promise to make regular periodic contributions to the fund.

Liquidity – How easy is it to sell my investment?

Mutual funds can be redeemed (sold back to the mutual fund company) on any business day. Since they don’t sell on the open market, shares sold during the course of the day will be priced at their net asset value at the end of the day. Hedge funds are not nearly as liquid. Many hedge funds have “lock-up” periods as long as five years, during which investors are not allowed to redeem their shares. Even after these lock-up periods have expired, hedge funds may require investors to give them several months advance notice of redemption requests. It should be noted here that not all hedge funds are subject to long lock-up periods or advance notice of redemptions. The liquidity of each hedge fund will most likely be dependent on the liquidity of the investments the hedge fund holds. Generally, mutual funds are far more liquid than hedge funds.

Transparency – What’s in there?

Most investors want to know something about what they’re invested in. Some like to know exactly what they’re invested in. If you are in the latter group, you are probably going to be much more comfortable with a mutual fund. Because they are required to register with the SEC, mutual funds have to report their holdings quarterly and they must stay within the investment parameters set forth in their prospectus. Hedge funds are not required to register with the SEC, and they are structured specifically to avoid most state and federal regulation. Therefore, any disclosure issues regarding the fund’s holdings are dictated by the terms of the private written agreements executed between the investor and the hedge fund. Most hedge fund managers take the position that frequent and detailed disclosure of investments would affect investment performance, and therefore most hedge fund operating documents provide for minimal disclosure. There have been increasing calls for regulation in this area.

Valuation – What’s this thing worth?

Mutual funds are required to provide daily valuations. Most mutual funds release that figure, called net asset value, shortly after the market closes for the day. Hedge funds have no such requirement and because of the nature of the assets they hold, current valuation may be difficult to determine without the benefit of an independent audit.

Fees – How much is this thing going to cost me?

Since investments costs obviously cut into returns, it’s vital to understand what those costs are. I could probably write a couple pages on mutual fund costs, but I’ll keep it short for the purposes of this piece. I’ll also limit the discussion to no-load funds because we don’t like load funds and we don’t use them. Mutual fund companies are in business to make money and they do that by charging fees. Most annual fees for mutual funds typically fall between .2% (yes, that’s two-tenths of one percent) and 2%. Some funds also charge an additional fee if you sell the fund within 90 days of purchase. Like mutual funds, hedge funds charge an asset management fee. Usually that fee will be between 1% and 2%. However unlike mutual funds, most hedge funds also charge a performance fee which allows them to take a set percentage of any profits generated. You may have heard the term “two and twenty” in reference to hedge funds. What this means is that the fund charges an annual 2% asset management fee, plus twenty percent of the profits. This provides an incentive for the fund manager to perform well, but it may also tempt him to take larger risks to juice up that performance.

Legal Protections

In an attempt to provide full disclosure and to prevent fraud, mutual funds are very highly regulated investment vehicles. Mutual fund companies are subject to direct oversight by the SEC and the large body of law contained in the Investment Company Act of 1940. The Act imposes a fiduciary duty upon the fund company to act in the best interest of those who invest in their funds. Although hedge funds fall under the general definition of investment company for purposes of the act, they carefully structure themselves so as to take advantage of one or more of the Act’s exemptions. There are legitimate reasons they do this, but the disadvantage to the investor is that the fund is not required to register with the SEC. Most of the differences between the two types of funds outlined here in Part II are a direct result of the legal environments they each work under. However, hedge fund investors are not without the protection of law. Despite their exempt status, hedge fund operators are fiduciaries, and if they breach that duty they are subject to legal action in the same manner that a mutual fund manager is. In addition, hedge fund managers are not exempt from the anti-fraud provisions contained in the securities laws and regulation. Finally, because the relationship between the fund and the investor is defined by the fund’s offering documents, a wronged investor may seek relief from the courts under standard contract law.

We have now covered what I consider the major differences between hedge funds and mutual funds. Keep in mind that for the sake of brevity I kept the comparisons general. Other issues that were not covered are differences in tax treatment, audit requirements, restrictions on advertising, custody of assets, internal oversight, and the significance of “offshore” hedge funds.

In part III I’ll discuss the relatively recent emergence of several traditional mutual funds which employ strategies historically used only by hedge funds.