From Mutual Funds to Hedge Funds; Understanding Investment Funds
When we are talking about investment funds, we often hear about mutual funds and hedge funds. Big differences lie between the two of them, but in both cases we are talking about a pooled investment vehicle, where many investors gather to take possession of a variety of financial assets. We will go through the characteristics of mutual funds, and then see how hedge funds are different.
The mutual funds
How does it work?
The mutual fund is a collective investment scheme of many investors pooling money together to purchase securities. When contributing, the investor becomes a shareholder of the fund, and every share owned represent a portion of the fund's net asset value. The investor is an owner, proportionally to the size of his contribution, of all the securities included in the managed fund. Therefore, instead of personally purchasing individual bonds or shares, he takes possession, in part, of an already diversified fund which includes multiple securities.
What type of funds can we find?
We can find four types of funds, related to the type of investment. Starting with the lowest risk, there is the money market funds, bond funds and equity funds. The investor will put his money in one of the funds in relation with his level of risk tolerance. Or, he could choose a fourth type, the hybrid funds, which combine the two or three types of investment, in which he can invest based on his risk assessment.
Another option would be to duplicate the shares included in a stock index, which is known as a passively managed fund, because it aims to follow the same market fluctuation. While an actively managed fund looks to beat the market by searching for promising investment opportunities ignored by the index (but at a higher management cost).
What are the incomes?
The participant of a mutual fund is making money with the bond's interest, share's dividend or capital gain when selling appreciated securities, all coming from a variety of financial assets included in the fund. Normally the revenues are redistributed to the shareholder after one year of management, with the option of reinvesting.
The investor can also make money by selling his shares of the fund, if they've gained value, since it is easily accessible to the public. In fact, most mutual funds are open-end, meaning the investor can sell or buy shares from a fund after every business day at its net asset value.
What are the main advantages?
Investors that are working as part of a group have the advantage of a stronger purchasing power, economies of scale and better diversifications. For the small investor, this opens up a greater variety of securities that wouldn't be accessible on an individual basis.
The risk is also better contained, because the participant becomes owner of a great amount of bonds and/or shares instead of just a few individual ones. He also can cash back the funds' share at any time at its daily value, so it is very liquid.
Moreover, by giving away our savings to professionals who work full time on managing it, mutual funds save the individual a lot time and effort. For the passive investor, it can offer a better risk / return ratio.
Are there any disadvantages to mutual funds?
This seems without faults, but after all, you are giving someone else the mandate of managing your money, an act that should not be done blindly. There are several costs to it and they are all billed to the investor. When the size of the funds gets bigger, managing the portfolio becomes a heavier task and therefore, expenses accumulate.
The funds' shareholder pays a management fee for the administration of the portfolio, which is a rate applied on the total asset. Another expense, called loads, is given to the salesperson for making the appropriate selection of the funds for the client. The better the assets perform and the bigger your investment becomes, the higher the fees.
These fees are taken directly from your initial investment and return on investment, which prevent the totality of your savings to compound. Also, fees could be passed under arcane financial terms for the common investor, and affect consequently the performance. The net return, after the expenses, are an aspect that brought many to reconsider the usefulness of mutual funds, when compared to what the average investor could accomplish on his own, if willing to invest the time.
Other than the costs, getting a better performance can become more difficult when the pool of financial assets is bigger. The risk is better contained, but the return as well. A security that is going well will be diluted in a major pool of bonds or shares, and won't have much of an effect on the entire portfolio.
The costs can bring many to wonder about the usefulness of mutual funds, however they are managed under established rules that attempt to protect the investor and avoid great losses, which is not the case with the hedge funds.
The Hedge Funds
What is a hedge fund?
Even though hedge funds follow a similar concept of investing as a group, it is not considered a mutual fund and is not advertised to the public. It doesn't follow the same rules as mutual funds, which has as an objective to protect the investor. Its main purpose is to obtain an unequaled return by taking greater risks in investing in the stock market, as well as other economical and commercial activities.
How is the hedge fund able to outperform?
The hedge funds are not looking to be passively managed and settled under a long position; its approach is to use aggressive strategies such as short selling, derivatives and financial leverage to get an outstanding performance. It is the most actively managed investment funds you can find, far from the safe strategies used in the mutual funds.
When leveraging, the funds seek to use the money gathered by the investors as a base to borrow elsewhere and increase the size of the portfolio. And by purchasing defensive securities (securities not fluctuating with the market) and short selling, the funds are looking into performing even in time of bear markets (when stocks are going down).
Who can participate in the hedge funds and what are the criteria?
The hedge funds gather up to a maximum of 100 participants, which limit its size. It is exclusive to rich individuals and institutions, because there are wealth criteria; a major one is to own more than a million in net value.
The minimum investment is also very high, without having any chances to cash it back for a rather long period of time, going from a few months to two years. The fund's net asset value is presented only at the end of the month, as opposed to mutual funds that present an adjusted net asset value every day with the option of cashing back shares at any time, which makes it very liquid.
In short, participants in hedge funds are investors with a deep pocket seeking to beat the market considerably, while risking big losses. In the end, these losses can be compensated with a very high return in specific sectors.
What are the costs related to the hedge funds?
The hedge funds managers have more freedom in their choices of investments, but at the same time, they have the major responsibility to seize opportunities in certain sectors and detect imperfections in the market. They are generally paid in relation to their performance and get up to 20% of the profits, which is way higher than the standard fees you would find in the mutual funds. The managers' competence is therefore a priority, because the hedge funds participants seek to get a good return, no matter how bad the market performs.
Mutual funds vs. hedge funds
The major difference between the two funds represents two poles of investment funds. A mutual fund targets everybody, at a modest cost, and protects the investors by purchasing only bonds and shares and staying very liquid. The hedge funds, for its part, have access to a greater number of financial instruments, with no constraints on the investment method, and impose a longer investment period to finalize the strategies.
For the small and average saver, there is no choice between the two funds. The choice is only given to the rich investors, because of the wealth criteria and the advanced and risky methods to obtain a considerable return used in the hedge funds. Even though most savers will join in the mutual funds, the hedge funds are still an important player in our economy. In fact, their actions can't be ignored, because with its speculative maneuvers, they often reveal imperfection in the market.