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Hedge funds vs mutual funds

Mutual Fund Education

Mutual Funds vs. Hedge Funds

Brian Mathews May 01, 2018



Knowing the differences between mutual funds and hedge funds is important for any investor, especially if they are considering whether to add either of these investment vehicles to their portfolios.


Investment Strategies


Hedge funds, by comparison, are designed to carry higher levels of risk because they lack the same level of regulations as mutual funds do. Bridgewater Associates L.P. is one of the largest hedge funds in the world, with over $160 billion in assets under management. The company’s longest running fund is the Pure Alpha Fund I, which was created in 1991 and is considered a managed futures fund. This fund has the ability to hedge, leverage and employ arbitrage methodologies with exposure to many different securities and futures markets. The fund’s strategy is to provide risk-adjusted returns that are uncorrelated with traditional asset classes like the equity and bond markets.

Most investors are attracted to hedge funds over mutual funds because of the expectation of higher returns. For example, one of the top performing hedge funds for 2018 so far is the Prism Partners, L.P, which has a long equity bias as a strategy. This fund is up over 25% for the year and has provided its investors with an average annual return of 20.18% since 1999. However, these excellent returns have come at great risk too, with its largest drawdown being over 56%.


Regulations


Hedge funds are not required to register with the SEC and are considered private offerings offered to specific investors that qualify. Therefore, hedge funds are not subject to the same four laws that mutual funds are, thus making them significantly less regulated. However, as most other investment vehicles, hedge fund managers must abide by a fiduciary standard and are subject to other laws like fraud and insider trading.


Investor Type


Hedge funds are a completely different story, with most requiring investors to be accredited. An accredited investor typically satisfies one of the two requirements: earned income of $200,000 ($300,000 jointly) for each of the last two years or a net worth of over $1 million (excluding primary residence). Since hedge funds are typically more risky and aggressive in nature, most generally grant only accredited investors who have a higher net worth and can withstand higher losses.


Fees


Hedge funds operate very differently, with both a management fee and performance fee. A common expression for hedge fund fees is the ‘’https://www.investopedia.com/terms/t/two_and_twenty.asp’ target=‘_blank’ rel=’nofollow’>Two and Twenty’ rule, where the fund charges an annual management fee of 2% and an incentive fee of 20%. The incentive fee is designed to inspire managers to perform very well, as they will earn 20% of all profits over a set benchmark every year, which is usually set around the 8% mark. This incentive fee can also be a wide range, from 10% to as high as 50% of profits.


Liquidity


Hedge funds have no requirements on its liquidity to its investors, which adds another element of risk. Some funds allow monthly subscriptions and redemptions, while some offer longer at quarterly and annual intervals. Many funds also require a ‘lock up’ period, where initial investors are not allowed to redeem their funds for a certain amount of time, such as one to two years. Both the illiquid nature and lockup periods add additional risk to anyone potentially interested in investing in a hedge fund.


The Bottom Line


On the other hand, if an investor not only qualifies for a hedge fund but more importantly is willing to withstand the risk and volatility that coincides with investing in one, the risk-adjusted returns might be worth it.

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