Hedge & Mutual Funds: What's the Difference?

Physician's Money Digest, March 2007, Volume 14, Issue 3

Hedge funds are privateinvestment limited partnershipsthat allow privateinvestors to poolassets to be invested bya fund manager, who is the generalpartner or entity that started and isresponsible for running the fund. Thisgeneral partner handles all of the tradingactivity and day-to-day operationsof running the hedge fund. The limitedpartners (ie, participants) are those thatsupply most of the capital, but do notparticipate in the trading or day-to-dayactivities of running the hedge fund.

A Little History

The first hedge fund was set up byAlfred W. Jones in 1949. Jones wantedto eliminate a part of the market riskinvolved in holding long stock positionsby short-selling other stocks. Hethereby shifted most of his exposurefrom market timing to stock picking.Jones was the first to use short sales,leverage, and incentive fees in combination.In 1952, he converted his generalpartnership fund into a limited partnership,investing with several independentportfolio managers and creating thefirst multimanager hedge fund. In themid-1950s other funds started usingthe short-selling of shares, although forthe majority of these funds, the hedgingof market risk was not central totheir investment strategy.

By design, hedge funds may investin a wide variety of investmentsranging from your typical equityand fixed-income investments toinvestments in derivative securities,distressed firms, currency speculation,convertible bonds, emerging markets,merger arbitrage, and so forth. Thehedge funds may jump from one assetclass to another as perceived investmentopportunities present themselves.

What hedge funds typically attemptto do is exploit temporary misalignmentsin security valuations. Byway of example, suppose the investmentmanager predicts that DaimlerChrysler (DCX) stock will outperformduring the coming year, whereasFord Motor Company (F) stock isexpected to do just the opposite—underperform. In such a case, theinvestment manager may exploitwhat they perceive to be an investmentopportunity by taking a longposition in DCX and shorting Ford.By implementing such a strategy, themanager is "hedging" their exposure,while making a bet on the relative valuationbetween the two companies.

Does this mean that taking such aposition is risky? Of course, the answeris "yes" insofar as the fund is speculatingin perceived valuation differencesbetween the two companies. This positioncould obviously be right orwrong, and if the fund utilizes leveragein such a transaction, returns can bequite volatile.

What Sets Them Apart

Unlike mutual funds that poolassets to be invested by a fund manager,hedge funds are structured as privatepartnerships and are subject tominimal SEC regulation. Typically,they are open only to wealthy or institutionalinvestors. Many hedge fundsrequire investors to agree to initial"lock-ups" of their money. In otherwords, investors typically agree to lockup their investment for periods as longas several years, during which timefunds may not be accessed or withdrawn.In this way, hedge funds mayinvest in illiquid assets (ie, assets thatare not easily and quickly convertedinto money) without having to worryabout meeting the demands for redemptionof funds.

Hedge funds also differ from mutualfunds in that their compensationstructure is markedly dissimilar. Forinstance, the typical equity mutualfund may assess annual managementfees in the neighborhood of 1% to1.5%, whereas hedge funds charge notonly an annual management fee, but"incentive fees" that are oftentimessubstantial. For instance, it would notbe unusual for the typical annualincentive fee to amount to 20% ofinvestment profits realized during thecourse of the year.

Despite such fees, hedge funds havegrown enormously in the past few yearsfrom as little as $50 billion in 1990 toover $1 trillion by the end of 2005. Oneof the fastest growing sectors has beenin "funds of funds." These types offunds invest in several hedge funds. Inthis way, the risk is spread across severaldifferent funds. Such a strategy is notwithout risks, however, as these fundsoperate with considerable leverage ontop of the leverage of the primary fundsin which they invest. This makesreturns even more volatile.

Rules and Regulations

Hedge funds also are not subjectto the numerous regulationsthat apply to mutual funds for theprotection of investors—such asrequiring a certain degree of liquidity,insisting that mutual fund sharesbe redeemable anytime, protectingagainst conflicts of interest, the assuringfairness in the pricing of fundshares, disclosing regulations, limitingthe use of leverage, and more. Thisfreedom from regulation allows hedgefunds to engage in leverage and othersophisticated investment techniques toa much greater extent than mutualfunds. Although hedge funds are notsubject to registration and all of theregulations that apply to mutual funds,hedge funds are subject to the anti-fraudprovisions of the federal securitieslaws.

Hedge funds generally rely on Sections3(c)(1) and 3(c)(7) of the InvestmentCompany Act of 1940 to avoidregistration and regulation as investmentcompanies. To avoid having toregister the securities they offer with theSEC, hedge funds often rely on Section4(2) and Rule 506 of Regulation D ofthe Securities Act of 1933.

Because of their growing popularity,hedge funds are attracting the attentionof regulators. And as this industrycontinues to grow, you can be sure thatregulation will increase as well. So doyour homework first and be carefulbefore you decide—if you decide—toinvest in a hedge fund.

Thomas R. Kosky and his partner, Harris L.Kerker, are principals of the Asset Planning,Group, Inc, in Miami, Fla. The companyspecializes in investment, retirement, andestate planning. Mr. Kosky also teaches corporatefinance in the Saturday Executive and Health CareExecutive MBA Programs at the University of Miami in CoralGables, Fla. Mr. Kosky and Mr. Kerker welcome questions orcomments at 800-953-5508, or e-mail Mr. Kosky directly atProfessorKosky@aol.com.