Hedge Funds vs Mutual Funds Understanding the Differences

By Dwyane Strocen

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 the sophisticated, or the accredited investor.

Mutual funds gained popularity in the 1980s.  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”).

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 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, though.  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 were part of the rules.

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 uncertainty, 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 Wall Street initiated financial meltdown 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.

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. On the other hand, hedge fund investing can be more difficult. There can be difficulty in locating a list of the availability of funds. There are, however, helpful data bases for this.  It is recommended that an investor undertake due diligence to ascertain if it is the right asset mix for his overall portfolio.

An investor needs to have an understanding of the different investment strategies.  Should he choose a value fund or a growth fund?   CTA funds are out-performing these days so he needs to think about a suitable bond fund.  He needs to ask if his fund employs hedging and should he invest in an off-shore fund to obtain the tax benefits.

Certainly there are many things to think about when selecting the proper investment vehicle.  Make your selection with intelligence and proper planning.  Ask around and be inquisitive. However, the level of investment knowledge and the time needed to devote to this topic will dictate which is best.

Dwayne Strocen manages the Genuine USA Index Program, a managed account program focused on the stock indices of the USA.