Question

1) Compare and contrast mutual funds and hedge funds (clients, risk, minimum investment, etc.). Give an example of a provider of each fund. Why might you not presently be a hedge fund client?

Answer 1

Hedge funds and mutual funds are both pooled investment vehicles wherein several investors entrust their money to a fund manager, who invest the same in different kinds of traded securities. but there are more differences than similarities. For example, a mutual fund is registered with the SEC, and can be sold to an unlimited number of investors whereas most hedge funds are not registered and can only be sold to carefully defined sophisticated investors. Usually a hedge fund will have a maximum of either 100 or 500 investors.

Differences :

Client- Hedge funds are only available to a specific group of sophisticated investors with high net worth. The U.S. government deems them as "accredited investors", and the criteria for becoming one are lengthy and restrictive. This isn't the case for mutual funds, which are very easy to purchase with minimal amounts of money.

Initial Investment - Hedge funds tend to be far more expensive for the investor and often have higher investment requirements. For example, a hedge fund may require a minimum of $1,000,000 as the initial investment whereas many mutual funds can be started for as little as $2,500.

Risk - Hedge funds are managed more aggressively than their mutual fund counterparts. They can take speculative positions in derivative securities such as options and have the ability to short sell stocks. This will typically increase the leverage - and thus the risk - of the fund. This also means that it's possible for hedge funds to make money when the market is falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged positions and are typically safer as a result.

Investment and Fees- Mutual funds allow you to invest in a basket of publicly traded securities run by an investment manager. In some rare cases they can own private placements in illiquid companies, but for the most part, they are responsible for selecting publicly traded securities, stock, bonds, etc. You can very easily buy mutual funds in a brokerage or retirement account. Fees are usually around 1%.

Hedge funds are private investment companies for accredited ($1M+ net worth) investors. Hedge funds can own anything, public securities, private securities, mines in Chile, real estate, even bitcoins, etc. You can't buy into a hedge fund via a brokerage or retirement account and most won't accept an investment of less than $250,000 to start. Most hedge funds are short term profit focused which can cause large tax bills for individual investors, when all the gains are short term capital gains, personal tax rates are much higher. Hedge funds can be much better for institutional investors because they don't have to pay short term capital gains taxes. Fees are usually 2% on assets and 20% of performance.

Liquidity- Another difference between hedge funds and mutual funds are the terms of when investors can and cannot redeem their units. Mutual fund investors can instruct a redemption on any given business day and receive the NAV (net asset value). Whereas some hedge funds offer weekly liquidity, some offer monthly, while others only allow redemptions quarterly or annually. Many hedge funds impose a lock-up period (a portion of time you must leave your money in the fund without the ability to redeem). During periods of market volatility such as the most recent financial crisis, several hedge funds suspended redemptions entirely in order to protect the remaining investors from a potential fire sale of the fund’s portfolio. It is important to carefully read the hedge fund’s offering memorandum to fully understand your redemption rights.

Purchase- Mutual funds are units, or shares, that can typically be purchased or redeemed as needed at the fund's current net asset value (NAV) per share. A fund's NAV is derived by totalling the assets in the portfolio minus any liabilities, then dividing by the total amount of shares outstanding. Hedge funds are more difficult to define, and the value of the assets can be more difficult to calculate. They were originally developed to invest in assets that provided a hedge to the general stock market. Hedge funds have become so diverse over the years that they can invest in commodities, currencies, interest rates, futures, derivatives etc. Therefore, Hedge Funds are no longer a uniform asset class.

Absolute vs. Relative- a hedge fund aims for absolute return (it wants to produce positive returns regardless of what the market is doing); the mutual fund is usually managed relative to an index benchmark and is judged on its variance from that benchmark.

Mutual Fund Companies: Vanguard, Fidelity, T. Rowe Price, or Schwab

Hedge Funds: Bridgewater Associates, Highbridge Capital Management(J.P. Morgan Asset Management), Paulson & Company , Blackrock Financial Management Inc.

We presently might not be a hedge fund client because the minimum investment requirements of a hedge fund are too large for a regular small retail investor like you and me.