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From Mutual Funds to Hedge Funds; Understanding Investment Funds

From Mutual Funds to Hedge Funds; Understanding Investment Funds When 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 proceed in seeing how hedge funds are different.

Mutual Funds

How does it work?

The mutual fund is a collective investment scheme where many investors pool money together in order to purchase securities. When contributing, the investor becomes a shareholder of the fund, and every share owned represents 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 types of funds can we find?

We can find four types of funds related to this type of investment. Starting with the one at lowest risk, there are: the money market funds, bond funds, equity funds and hybrid funds. The investor will put his money in one of the funds depending on his level of risk tolerance. The hybrid fund is particular in that it can combine two or three types of investments.

Another option would be to duplicate the shares included in a stock index, known as a passively managed fund, which aims to follow the market's fluctuation. In comparison, an actively managed fund looks to beat the market by searching for promising investment opportunities ignored by the index (these generally have a higher management cost).

What are the incomes?

The participant of a mutual fund is making money with the bond's interest, share's dividends or capital gains 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 reinvestment.

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-ended, 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 work as part of a group have the advantage of having stronger purchasing power, economies of scale, and better diversification. 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 can also cash back the funds' shares at any time, at its daily value, so it is very liquid. Moreover, by letting professionals manage the fund, mutual funds save the individual a lot time and effort and for the passive investor, it can offer a better risk/return ratio.

Are there any disadvantages to mutual funds?

Although mutual funds seem ideal, you are still giving someone else the mandate of managing your money, an act that should not be taken blindly. There are several costs related to the management of the fund which need to be considered, and which of course, are billed to the investor. When the size of the fund increases, managing the portfolio becomes more complicated and therefore, expenses accumulate accordingly.

The funds' shareholders pay 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 hidden financial terms for the common investor, and affect the fund’s performance. The net return, after expenses, is an aspect that brought many to reconsider the worthiness of mutual funds, comparing to what the average investor would be able to accomplish on his own, if willing to invest the time.

Other than the costs, getting a fund to perform better becomes harder 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 ultimately won't have much of an effect on the entire portfolio.

In the end, even though the costs can be high, mutual funds are managed under established rules that attempt to protect the investor and avoid great losses, which is not the case with hedge funds.

Hedge Funds

What is a hedge fund?

Even though hedge funds follow a similar concept, that of investing as a group, they are not considered mutual funds, and are not advertised to the public. They don't follow the same rules as mutual funds and their main purpose is to obtain an unequaled return by taking greater risks investing in the stock market, and in other economical and commercial activities.

How is the hedge fund able to outperform?

Hedge funds are not looking to be passively managed and settled under a long position; their approach is to use aggressive strategies such as short selling, derivatives and financial leverage in order to get an outstanding performance. They are the most actively managed investment funds you can find, far from the safe strategies used in mutual funds.

When leveraging, the funds seek to use the money gathered by the investors as a base in order to borrow elsewhere and increase the size of the portfolio. By purchasing defensive securities (securities that do not fluctuate with the market) and short selling, the funds look to perform even in times of bear markets (when stocks go down).

Who can participate in hedge funds and what is the criteria?

Hedge funds can gather up to a maximum of 100 participants. It is exclusive to rich individuals and institutions, and has a wealth-criteria (i.e. to buy into a major hedge fund you might need to own more than one million dollars in net value).

The minimum initial investment is also very high and you wouldn’t be allowed to cash it back out for a rather long period of time, ranging from a few months to two years. The fund's net asset value is presented only at the end of each month, as opposed to mutual funds which present an adjusted net asset value every day, and from which you have the option of cashing back shares at any time.

In short, participants in hedge funds are investors with deep pockets seeking to beat the market considerably, but also risking big losses. In the end, these losses are compensated with very high returns in specific sectors.

What are the costs related to hedge funds?

Hedge fund managers often have more freedom in their choices of investments, but at the same time, they have the major responsibility of taking the right decisions, seizing opportunities in certain sectors, and detecting imperfections in the market. They are generally paid in relation to their performance and can get up to 20% of the profits, which is way higher than the standard fees you would find in mutual funds. The managers' competence is therefore a priority since the hedge fund participants seek to get a good return, no matter how bad the market performs.

Mutual Funds vs. Hedge Funds

As we have seen, there are big differences between both funds. Mutual funds target everybody, at a modest cost, and protect investors by purchasing only bonds and shares while remaining a very liquid asset. Alternatively, hedge funds target only people with big wealth, have access to a greater number of financial instruments with no constraints on the investment method, and impose a longer investment period in order to finalize the strategies chosen.

For the small and average saver, there is no choice between the two funds. The choice is only given to rich investors, because of the wealth criteria required in hedge funds, which as explained, uses advanced and risky methods in order to obtain considerable returns. Even though most savers will purchase mutual funds, hedge funds are an important player in our economy. In fact, their actions can't be ignored, because with their speculative maneuvers, they often reveal imperfections in the market.

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