Hedge Fund vs Mutual Fund, Understanding The Differences
April 1, 2010 09:26pm
Hedge funds and mutual funds have many similarities, but many differences
exist as well. Know the benefits of each before making the decision to invest.
In 1949 Australian Alfred Jones was credited with the term "hedge fund".
Historically it derives its name from the use of hedging to manage risk while achieving
superior returns. Today, a hedge fund is an un-regulated investment vehicle designated
for sophisticated, also known as the "Accredited Investor".
Mutual funds gained popularity in the 1980's. Prior to this time, the problem
of the small investor was in obtaining sufficient knowledge to make informed investment
decisions, and so the average person avoided stock market investing. Instead money was held
in traditional savings accounts or placed with a bank in a Guaranteed Investment Certificate
("GIC") or Certificate of Deposit ("CD").
What to do. The small investor was not able to obtain a professional money
manager without $10 million or more to start. But what if he could pool his money with
other small investors to reach this minimum threshold. And so the mutual fund was created
to address these exact concerns.
The mutual fund concept was simple, allow the un-sophisticated investor access
to the strategies of the professional money manager. This was done by pooling small sums of
money, as little as $20.00 deposited monthly. In return, the fund company would use professional
money managers using professional investment strategies to easily out perform traditional
bank savings products.
The mutual fund investor had other problems. Because they did not understand
the nature of the investments made for them, government regulators got involved to protect
investor rights. And so mutual fund investing became regulated and soon took on a life of
its own. Rules were set in place to govern what could be held within a mutual fund and how
the investment strategies were marketed to the public. Even what could be invested and what
should be avoided.
While much evolution has transpired since the early days of the 80's. One
thing is for certain, mutual fund investing is all about what it cannot do. While this
article is not focused on these issues, there are some glaring examples the investor needs
to know. In times of market un-certainty, the mutual fund cannot sell and move to cash for
safety. The manager must remain fully invested at all times making the investor, in
consultation with his Investment Advisor, responsible for proper asset allocation. The mutual
fund also cannot employ risk management or hedging techniques because they are deemed too
sophisticated for the small investor to understand. So to avoid investor complaints, these
important strategies are discouraged by managers and outlawed by regulators.
In the end, all of the benefits started by the mutual fund industry to
provide safety of capital have been regulated away from the interests of the small investor.
In fact, these are the exact investors which need safety of capital most of all. Many
market observers believe the industry has become over regulated and as such, do more
harm than good.
To-date, the hedge fund industry has been able in all country jurisdictions
to avoid nuisance government meddling. The recent wall street initiated financial melt
down has proven that even a self regulated industry is not immune. It seems big company
rights take precedence over investor rights. So some regulation may be forth coming.
Historically, the hedge fund industry has been able to avoid regulation by offering its
products only to the Accredited Investor. There is a strict agreed upon formula based
on wealth accumulation. The premise being if you were smart enough to accumulate wealth,
then you are smart enough to understand the sophisticated investments being recommended.
Typically hedge fund investors are in direct contrast to mutual fund
investors and thus have different needs. The mutual fund investor has modest wealth
and little investment knowledge. The hedge fund investor has significant wealth with
greater investment understanding. Therefore one is regulated to protect the investor
and the other is not.
The above description is not the only difference that separates the two.
Hedge funds can employ a complex strategy of investment vehicles known only to the
fund manager. Many hedge fund managers are protective of any proprietary trading
formula which will provide an edge over their competition and disclosure of their
trading style is not required.
Mutual funds are sold through an Investment Advisor who will make
comparisons, explain and make recommendations for a balanced portfolio. Hedge fund
investing can be more difficult. Firstly, there can be difficulty in locating a list
of the availability of funds. There are however helpful data-bases for this. Then
you must undertake your own due diligence to ascertain if it is the right asset mix
for your overall portfolio.
Thirdly, you'll need to have an understanding of the different
investment strategies. Do you choose a value fund or a growth fund.
CTA funds
are out performing these days and what about a suitable bond fund. Does my fund employ
hedging and should I invest in an off-shore fund to obtain the tax benefits.
There are certainly many things to think about when selecting the proper
investment vehicle. Make your selection with intelligence and proper planning. Ask
around and be inquisitive. Your level of investment knowledge and the time needed to devote
to this topic will dictate which is best for you.
Dwayne Strocen is a registered Commodity Trading Advisor specializing in analyzing and hedging Market
and Operational Risk using exchange traded and OTC derivatives.
View more detailed information about his CTA funds
and Who We Are .
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