Oran Hall | Mutual funds versus hedge funds

QUESTION: What is the difference between a mutual fund and a hedge fund?

– Jaden

FINANCIAL ADVISER: Mutual funds and hedge funds are investment funds that pool investors’ money and invest it in a wide variety of assets, but they differ from each other in many ways.

These pooled investment funds are similar in several ways: they may have front-end or back-end fees, they charge management fees, and they can be bought or sold through an investment dealer. The terms hedge fund and mutual fund do not describe a particular investment style but describe a type of fund structure.

There are many different types of hedge funds and mutual funds, and they employ many different investment strategies. For example, some mutual funds invest solely in equities or solely in bonds and some invest in a combination of equities and bonds, and some mutual funds employ a passive investing strategy, but others an active investing strategy.

On the other hand, there are many different types of hedge fund styles – such as global macro, and convertible arbitrage – and hedge funds have more flexible investment strategies. Some hedge funds, in fact, do not even use hedging strategies.

Mutual funds issue a prospectus, hedge funds an offering memorandum. This is a legal document stating the objectives, risks and terms of investment involved with making a private placement. Compared with a prospectus offering, an issuer selling securities under an offering memorandum is subject to much lower minimum initial and ongoing investor information requirements.

Whereas mutual funds are available to all kinds of investors, hedge funds are for accredited investors – investors having a minimum level of income, net worth and investment knowledge. Such investors are generally considered to be better able to understand and appreciate the risks associated with the funds and do not require the same amount of information as an investor in a mutual fund. Thus, hedge fund investors tend to be high net worth individuals and institutional investors, such as pension funds and insurance companies

Hedge funds are managed more aggressively than mutual funds. They borrow to increase investor exposure and risk with a view to increasing returns, but this also increases the possibility of loss. They also take long and short positions, use arbitrage, use derivatives like options and futures, and invest in almost any situation in any kind of market in which the manager sees an opportunity to achieve positive returns. Mutual funds, on the other hand, do not include short positions and use derivatives only in a limited way.

Whereas the assets of the mutual fund manager are not usually invested in the fund, the assets of the hedge fund managers tend to make up a significant part of the hedge fund at start-up. They tend to invest their own capital in the fund to show their commitment to it and to align their interests with the interests of the investors.

Whereas mutual funds are usually quite liquid, hedge funds may have liquidity restrictions. Mutual fund investors may sell their shares on any given trading day, but hedge fund investors may have limited opportunities to redeem theirs, for example, monthly or quarterly. Hedge funds may also suspend redemptions under certain circumstances, for example, in times of market distress.

It is usually quite easy to value mutual funds. It may be more difficult to do so in the case of hedge funds as some may be invested in highly illiquid securities that may be difficult to value.

Mutual funds come under tighter regulatory oversight, but hedge funds are generally considered to be lightly regulated and therefore offer less protection to investors. At the same time, although there are no performance-based fees associated with mutual funds, such fees are associated with hedge funds.

Mutual funds and hedge funds have contrasting return objectives. Mutual funds, for example, focus on relative return objectives: performance is usually measured against a benchmark. Hedge funds, however, focus on absolute return objectives, so the fund is expected to make a profit under all market conditions.

Mutual funds are available in the Jamaican market, but not hedge funds. They are similar in several ways but vary in significant ways. Mutual funds are for a wide range of investors, but hedge funds are for the sophisticated and deep-pocketed.

- Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com