Hedge Funds vs. Mutual Funds

by Derek Loosvelt | March 31, 2009

The closest cousin to hedge funds in the financial services world is the mutual fund. There are some similarities between the two, but there are several important differences as well. Here's a look at some of them.

Free choice of asset classes

The term "asset class" means a type of instrument, such as stocks, bonds, real estate or cash. As an example, stocks are a separate asset class from bonds. Financial instruments are instruments that have some monetary value or they record a monetary transaction. Stocks, bonds, options and futures are all examples of financial instruments.

Free choice of asset classes means the type of asset categories that the hedge fund manager can and will invest in is usually very broad. The types of assets (stocks, bonds, cash, commodities, etc.) in which the hedge fund may invest are outlined in the investment mandate (fund prospectus) that is given to investors before they invest into the hedge fund. In addition, the investment mandate details the exact trading strategies that the hedge fund employs.

Most mutual funds use only bonds or only equities to generate returns, as stipulated by their investment mandate. In comparison, hedge funds mandates may allow a wider variety of asset classes: equities, debt, commodities and derivative products. Hedge funds can also trade in bank debt, currencies, and futures the whole gamut of investment opportunities.

Not all hedge funds allow a wider variety of asset classes; long/short equity managers might restrict their investment mandate to strictly stocks (equities). Other hedge funds may allow stocks, interest rates swaps, currencies and commodities and literally have no asset class investment restrictions; an example would be global macro hedge funds. (A detailed description of the global macro strategy is outlined in the hedge fund strategy section.)

Free choice of markets

"Markets" is the general term for the organized trading of stocks through stock exchanges (stock markets). The main stock markets in the world are the NYSE, NASDAQ, London Stock Exchange, and Tokyo Stock Exchange.

Free choice of markets means that many hedge funds do not focus on one specific stock market. Not limiting investment opportunities to one market gives hedge funds the option to act on investment opportunities throughout the world. Many hedge funds, like most mutual funds, will specify that they strictly focus on the U.S. markets (NYSE and NASDAQ) while global macro and international mutual funds will leave their mandate broad enough to allow them to invest in many markets (U.S., Europe, Asia and emerging markets). This allows the managers to invest where they see opportunity to profit.

Free choice of trading style/strategy

A "trading strategy" refers to the investment approach or the techniques used by the hedge fund manager to have positive returns on the investments.Most hedge funds choose to confine themselves to one specific strategy. (Strategies are explained in detail later.) Examples include the "statistical arbitrage" strategy or "long/short equity" strategy. These managers would detail in their investment mandate that the fund only invests in long/short equities or follows a statistical arbitrage model. However, some hedge funds leave their mandates vague to allow them to exploit opportunities when they become available or to simply change strategies. By having a broadly defined strategy, the manager could continue to generate returns for their investors given many different market conditions.

Transparency (or lack thereof)

"Transparency" refers to the amount of trading disclosure that hedge fund managers have to give to the SEC (Securities and Exchange Commission) and their investors. "Trading disclosure" refers to revealing actual trades, portfolio positions, performance and assets under management.

Mutual funds have to disclose their positions to the SEC on a frequent basis, at least every quarter. Currently, hedge fund managers are not required to disclose security positions and balances to their investors and the SEC. This lack of transparency within the hedge fund industry can be viewed both positively and negatively. Hedge fund managers tend to use proprietary trading strategies and attempt to exploit market inefficiencies before other managers discover them. Therefore, disclosing their positions/trades could compromise their strategy and result in other managers poaching their strategies or trading against them. Most hedge funds limit the disclosure of performance and asset size to existing and potential investors.

High minimum investment levels

To be classified as a private investment pool under SEC rules (thereby not having to be subject to the same reporting requirements as mutual funds), hedge funds must comply with regulatory restrictions on the type of investors and the number of investors who can invest in their fund. Most hedge funds require a minimum investment of $1 million to $5 million, although many of the larger funds require at least $10 million as a minimum investment.

Filed Under: Finance


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