Mutual funds verses Hedge funds

What is the difference between a Mutual fund and a Hedge fund?

There are five key distinctions:

1. Mutual funds are measured on relative performance - that is, their performance is compared to a relevant index such as the S&P 500 Index or to other mutual funds in their sector. Hedge funds are expected to deliver absolute returns - they attempt to make profits under all circumstances, even when the relative indices are down.

2. Mutual funds are highly regulated, restricting the use of short selling and derivatives. These regulations serve as handcuffs, making it more difficult to outperform the market or to protect the assets of the fund in a downturn. Hedge funds, on the other hand, are unregulated and therefore unrestricted - they allow for short selling and other strategies designed to accelerate performance or reduce volatility. However, an informal restriction is generally imposed on all hedge fund managers by professional investors who understand the different strategies and typically invest in a particular fund because of the manager's expertise in a particular investment strategy. These investors require and expect the hedge fund to stay within its area of specialization and competence. Hence, one of the defining characteristics of hedge funds is that they tend to be specialized, operating within a given niche, specialty or industry that requires a particular expertise.

3. Mutual funds generally remunerate management based on a percent of assets under management. Hedge funds always remunerate managers with performance-related incentive fees as well as a fixed fee. Investing for absolute returns is more demanding than simply seeking relative returns and requires greater skill, knowledge, and talent. Not surprisingly, the incentive-based performance fees tend to attract the most talented investment managers to the hedge fund industry.

4. Mutual funds are not able to effectively protect portfolios against declining markets other than by going into cash or by shorting a limited amount of stock index futures. Hedge funds, on the other hand, are often able to protect against declining markets by utilizing various hedging strategies. The strategies used, of course, vary tremendously depending on the investment style and type of hedge fund. But as a result of these hedging strategies, certain types of hedge funds are able to generate positive returns even in declining markets.

5. The future performance of mutual funds is dependent on the direction of the equity markets. It can be compared to putting a cork on the surface of the ocean - the cork will go up and down with the waves. The future performance of many hedge fund strategies tends to be highly predictable and not dependent on the direction of the equity markets. It can be compared to a submarine travelling in an almost straight line below the surface, not impacted by the effect of the waves.
    

What is a fund of funds, and what is the advantage of investing in one versus a hedge fund?

A fund of funds is a fund that mixes and matches the most successful hedge funds and other pooled investment vehicles, spreading investments among many different funds or investment vehicles. As we've noted, hedge fund strategies are complex and varied in their ranges of risk/return Even within a particular style, no two managers are likely to be exactly the same. Each will apply different amounts of hedging or insurance to his/her portfolio and will employ different amounts of leverage. A fund of funds simplifies the process of choosing hedge funds, blending together funds to meet a range of investor risk/return objectives while generally spreading out the risks among a variety of funds. This blending of different strategies and asset classes aims to deliver a more consistent return (than any of the individual funds).

Among the advantages:

Creating a fund of funds can be likened to baking a cake. Working from the same ingredients such as flour, butter, sugar, yeast, eggs, etc., a baker is capable of producing different cakes. For example:

So it is with a funds of funds. Understanding the characteristics and risk profiles of the different hedge fund strategies allows the fund of funds manager to blend funds together that often are able to produce fairly predictable returns.
 

So predictability of return is greater with a fund of funds?

Yes. In any investment strategy the predictability of future results is strongly correlated with the volatility of past returns of each strategy. Future performance of strategies with high volatility is far less predictable than future performance of strategies experiencing low or moderate volatility. Participants in the mutual fund industry, where the volatility of past results is high (because results are so dependant on the direction of the stock market), know how impossible it is to predict future performance. However, within the hedge fund industry many of the hedging strategies are able to produce consistent returns which are highly predictable.

As a result, focused funds of funds, utilizing some of these low-volatility strategies, are often able to produce predictable returns, not correlated to market direction.
 

What place should hedge funds or funds of funds have in investment portfolios given today's investment climate?

Equity markets, with the exception of Japan and emerging markets, have enjoyed an unprecedented boom for the last decade (1990 to 2000) - in fact, the U.S. has enjoyed the longest bull market of this century. Given the vulnerability of the U.S. markets to a correction, which if it happened would undoubtedly trigger a downturn in global markets (which has happened, and the recent downturn led by the US market had a world wide impact, affecting almost every market and investor alike.) it would be prudent for everyone in the investment industry, including private investors, to allocate at least a portion of their investment portfolios to hedge fund strategies  that are not correlated to the direction of equity markets (Which most now wished they had. The average hedge fund performed as normal during the recent market down turn, whilst the average mutual fund posted disastrous losses.) Keeping in mind that not all hedge funds are the same, any investor can probably find a strategy within the hedge fund universe that best suits their risk profile and investment style.
(Comments of the STAR Financial investment team)

By Dion Friedland, Chairman, Magnum Funds