Hedge Funds: Mutual Funds' Twin Brother?

Ever since their creation in 1949 by A. W. Jones (www.hedgefund.com), hedge funds have been widely regarded as a unique and lucrative alternative to investing one's money. Some have seen them as a replacement to the well-known mutual fund, while others believe they are an entirely new domain. Besides defining both the hedge fund and mutual fund, this paper aims to expose the answer to a deeper question: are hedge funds really different than a mutual fund, and if so, how and why? By comparing both financial intermediaries in the areas of structure, strategy, and their respective environments, any uncertainties that may reside within these financial institutions can be resolved.

The most basic question that must first be answered is the most obvious: what is a hedge fund and what is it made of? Hedge funds are partnerships wherein the manager or general partner has a significant personal stake in the fund and is free to operate in a variety of markets and to utilize investments and strategies with variable long/short exposures and degrees of leverage. (Ineichen) In other words a hedge fund is a special type of mutual fund (Mishkin) - which on a very basic level is correct. However, it is crucial to note that mutual funds are referred to as "public", while hedge funds are referred to as "private." This opens a portal of regulatory issues between the mutual fund and hedge fund entities. Mutual funds, where thousands are available in the United States alone, are among the most highly regulated financial intermediaries. Thus they are subject to a very large number of requirements that insure that they act in the best of interests of their "public" shareholders.

To digress only briefly, it is important to mention the importance of regulatory enactments since the early twentieth century because they have an enormous impact on today's companies. Four of the most influential acts include the Securities Act of 1933, the Securities Exchange Act 1934, the Investment Company Act of 1940, and the Investment Advisors Act of 1940. One of the more important acts, with respect to mutual funds, is the Investment Advisors Act of 1940. Most importantly the act requires the disclosure of their financial condition and investment policies when the stock is sold, and continually on a regular basis. On the other hand, hedge funds are not registered, and are, as previously mentioned, private investment "pools." For the most part they are exempt from the regulation by the SEC under the federal securities laws. Unlike many of the limits imposed on mutual funds, hedge funds are granted a great deal of privacy. They aren't required to disclose investing strategies, composition of their portfolios or performance besides what the company willingly presents. (IMF) Undoubtedly this allows hedge funds more of a decisive edge to plan and implement further internal and external tactics to better optimize their institution.

In analyzing both hedge and mutual funds, is it also important to look at the advantages, and implicit disadvantages, from the manager's point of view, as well as the investor's point of view. One major difference that cannot be ignored is the difference in fees. In this category mutual funds present a major disadvantage as they are allowed to impose only certain fees under the limitations of specific guidelines. This can be demonstrated when the federal law requires them to act out of a "fiduciary duty," as well as impose sales charges and distribution fees subject to NASD rules. (Nicholas) Hedge funds, again, have far less constraints, as seen from the manager's point of view. This is exemplified in their ability to charge any fee to their investors. It is quite normal for the hedge fund to receive 1% - 2% of net assets. This is a substantial amount if one can imagine that in most cases the minimum investment in a hedge fund is around 1 million dollars. In addition, they typically take 20% of the annual return. Again the hedge fund's freedom in their compensation is a result of regulatory differences mentioned above. Thus we can conclude that from the standpoint of the managers, the hedge fund again has an advantage because the structure of a hedge fund allows it to escape many suffocating regulations.

On a different subject, the biggest difference between the two funds is leverage. Leverage is defined as the degree to which an investor (or fund) can utilize borrowed monies. (www.investorwords.com) The 1940 Investment Company Act sternly restricts the amount to which a mutual fund can leverage their securities. Additionally the SEC requires that they "cover" (a covered call or put option) their positions. Here the hedge fund has an almost absolute advantage. Leverage is almost a benchmark of hedge funds. Most mutual fund managers are typically constrained to buying and holding assets in a well defined number of asset classes and are frequently limited to little or no leverage (unlike hedge funds).

The issue of leverage is only one difference between the two types of funds and a perfect segue into the different investing strategies that the two employ. Obviously it is impossible to try and explain each and every technique that they utilize, but the understanding of the general concepts will help differentiate the two. In order to help understand their methods, we have to identify their slightly different goals. It is unambiguous that they both wish to make a profit. But hedge funds usually work to realize "absolute performance" whereas mutual funds are more on a "relative performance basis," thus mutual funds could lose money over an extended period of time, but if the losses are less than the average or index that the fund is compared to, the fund can still be considered as "successful." In contrast the "absolute performance" that the hedge fund aims for is measured strictly on a profit basis. (www.planethedgefund.com)

More specific than just diversification, both funds can have complex strategies. The simpler of the two is

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