MONEY and BANKING PAPERS LOW GRAPHICS

 


Funds: Hedge and Mutual-
Who and What They Are


by Soam Prakash Lall
 

 

Ever since their creation in 1949 by A. W. Jones, hedge funds have been widely regarded as a unique and luring alternative to investing ones money. Some have seen them as a replacement to the well-known mutual fund- while others believe that they are an entirely new domain. Besides defining both the hedge fund and mutual fund, this paper aims to expose the answer to a deeper question: Are hedge funds  REALLY different than a mutual fund, and if so, how and why? By comparing both financial intermediaries in the areas of structure, strategy, and their respective environments, it is my hope that I can unmask any uncertainties that may reside within these financial institutions.

The most basic question that must first be answered in this type of paper is the most obvious: what is a hedge fund, and how or what is it made up of?  Mishkin describes a hedge fund as a special type of mutual fund - which on a very basic level is correct.  But here we must be careful, while mutual funds are referred to as “public” hedge funds are referred to as “private.” This opens a portal of regulatory issues between the mutual fund and hedge fund entities.  Mutual funds, and there thousands of them in the United States alone, are among the most highly regulated financial intermediaries. Thus they are subject to a very large number or requirements that insure that they act in the best of interests of their “public” shareholders.

 

To digress only briefly, it is important to mention the importance of regulatory enactments since the early twentieth century because they have an enormous impact on today’s companies. Four of the most influential  acts include the Securities Act of 1933, the Securities Exchange Act 1934,
the Investment Company Act of 1940, and
the Investment Advisors Act of 1940. (Hyperlinks to definitions included)  While we briefly discussed the implications of some of these acts in class,  one of the more important acts, with respect to mutual funds, is the Investment Advisors Act of 1940. Most importantly the act requires the disclosure  of their financial condition and INVESTMENT POLICIES when the stock is sold, and continually on a regular basis. On the other hand, hedge funds are not registered, and are, as previously mentioned, private investment “pools.” For the most part they are exempt from the regulation by the SEC under the federal securities laws.  Unlike many of the limits imposed on mutual funds, hedge funds are granted a great deal of privacy.  They aren’t required to disclose investing strategies, composition of their portfolios or performance besides what the company willingly presents. Undoubtedly this allows hedge funds more of a decisive edge to plan and implement further internal and external tactics to better optimize their institution. [Source: IMF]

In analyzing both hedge and mutual funds, is it also important to look at the advantages, and implicit disadvantages, from the managers point of view, and not only the investors point of view. One major difference that cannot be ignored is the difference in fees. In this category mutual funds present a major disadvantage as they are allowed to impose only certain fees under the limitations of specific guidelines. An example of this that federal law requires them to act out of a “fiduciary duty,” as well as impose sales charges and distribution fees subject to NASD rules. Hedge funds, again, have far less constraints, as seen from the manager’s point of view. This is exemplified in their ability to charge any fee to their investors. It is quite normal for the hedge fund to receive 1% - 2% of net assets. ( This is a substantial amount if one can imagine that in most cases the minimum investment in a hedge fund is around 1 million dollars.) In addition, they typically take 20% of the annual return. Again the hedge fund’s freedom in their compensation is a result of regulatory differences mentioned above. Thus we can conclude that from the standpoint of the managers, the hedge fund again has an advantage. [Source: ICI, Nicholas]

 

What we have mentioned above concludes the discussion of the advantages (and disadvantages) that the two types of funds have with respect to regulatory issues. We have not only described the type of environment that the two funds are in, but furthermore come to the conclusion that the very structure of a hedge fund allows it to escape many suffocating regulations. The next part of this essay will discuss, the practices within the funds. What strategies do both type of funds utilize and moreover what strategies are they ALLOWED to employ?

[The principle resources for the following section of strategy are two papers: “A Primer on Hedge Funds,” and “Performance Attribution and Style Analysis: From Mutual Funds to Hedge Funds” both by William Fung and David Hsieh. They will be referred to as Paper 1 and Paper 2 respectively]

We will start with the biggest difference between the two funds: leverage. Leverage is defined as the degree to which an investor (or fund) can utilize borrowed monies. [Investorwords]   The 1940 Investment Company Act sternly restricts the amount to which a mutual fund can leverage their securities and additionally the SEC requires that they “cover” (a covered call or put option)  their positions. Here the hedge fund has an almost absolute advantage, if one would like to call it that. Leverage is almost a benchmark of  hedge funds. In Paper 1 they accurately portray the opposing strategies, “most mutual fund managers are typically constrained to buying and holding assets in a well defined number of asset classes and are frequently limited to little or no leverage [unlike hedge funds].”

The issue of leverage is only one difference between the two types of funds and a perfect segue into the different investing strategies that the two employ. Obviously it is impossible to try and explain each and every technique that they utilize, but the understanding of the general concepts will help us differentiate the two.  In order to help us understand their methods, we have to identify their slightly different goals. It is unambiguous that they both wish to make a profit. But hedge funds usually work to realize “absolute performance” whereas mutual funds are more on a “relative performance basis,” thus mutual funds could lose money over an extended period of time, but if the losses are less than the average or index that the fund is compared to, the fund can still be considered as “successful.” In contrast the “absolute performance” that the hedge fund aims for is measured strictly on a profit basis. [planethedgefund.com]

 

More specific than just diversification, both funds can have complex strategies. The easier of the two is the mutual fund. First off, the mutual fund is highly concentrated in the domestic (U.S.) stock and bond market. Furthermore they have a very traditional approach,  that is the “buy-and-hold strategy.” It cannot be ignored that there are indeed more differences among the mutual fund market, for example there are more aggressive funds that are higher in risk due to choice of investments (i.e. new technologies), and there are those mutual funds that are more of a long term, low-risk that yield a monthly dividend. On the whole, however, there actual investing strategy is as old as the stock market itself- buy, hold, and sell on the way down. [Leggmason]

The whole idea of the hedge fund is that there is a “hedge” against your investment. To explain, further, that securities have more downside protection than would otherwise be possible. Mr. Jones, the “inventor” of the hedge fund protected his initial long position, with a respective short position; for example: he would buy long on a stock he thought undervalued (and hope the stock would go up) and go short on a stock he thought was overvalued (and hope the stock would go down)- there by, reducing the inherent risk of both of these investments in separate isolation. The preceding example is an extreme simplification of what goes on in today’s modern hedge fund environment. While the mutual fund has only one principle method by which they actually invest, hedge funds have a variety. Following the bibliography of this paper you can find a more in depth definition of some hedge fund strategies as described by Fung and Hsteh. They include market neutral fund, different types of arbitrage funds, and different type of equity funds.  In addition to these “dynamic” strategies (mentioned in some detail at the end of the paper) there are also complex derivative instruments that are well beyond the scope of this paper. Furthermore for a more analytical description of some of the strategies , Paper 2 by Fung and Hsteh would be more insightful. For the purpose of this paper, I have tried to convey the absolute complexity of the hedge fund’s investment strategies. While trying not to ignore some of the similarities between the mutual fund and hedge fund strategies such as market timing and general diversification. But the obvious must again be reinstated that due to some of the regulatory allowances, in the case of hedge funds,  they are allowed to utilize strategies, albeit risky, that are complex and more far-reaching than any mutual fund can offer. Thus, Fung and Hsteh summarize the difference by simply stating that, “One fundamental difference is that hedge funds deploy dynamic trading strategies whereas most mutual funds employ a static buy-and-hold strategy.” [Fung and Hsteh]

 

But have we really answered the question that this paper was initially trying to ask? Do hedge funds REALLY differ from mutual funds, or are they as Mishkin put it, “ a special type of mutual fund.” I think it is without any dissent that we can conclude that they are indeed quite different. We have seen many of the sources of their difference, chiefly residing in the regulations that have mounted over the years. While we have stated the facts as to why, and how they differ, it is my opinion that this paper would fall short if it did not address one final issue. That is the same issue that was asked on the midterm- fundamentally speaking, why would one choose a hedge fund? This was indirectly asked in the form of the question, “If you had 1 million dollars how would you invest it?” Ultimately it is up to the investor. Is he/she risk averse? What time constraints do they have, long term or short term. Are they aggressive or non-aggressive? Thus it really doesn’t matter how or why the typical mutual fund differs from the hedge fund, rather, the investor makes most of the decisions, the mutual and hedge fund are just the means by which they make their investment.

 

References:

 

Mishkin, Frederic S,  The economics of Money, Banking,
and Financial Markets. 

            Addison Wesley Publishing, 2003, pp. 325-327

Nicholas, Joseph G., Investing in Hedge Funds, Bloomberg Pr, 1999

 

Web Sources:

 

Papers by Fung and Hsteh:

 

“Performance Attribution and Style Analysis: From Mutual Funds to Hedge Funds”

http://www.london.edu/hedgefunds
/Hedge_Fund_Centre/Published_Papers/style.pdf

“A Primer on Hedge Funds”

http://faculty.fuqua.duke.edu/~dah7/primer.pdf

 

Planet Hedge Fund: How Do Mutual Funds Differ From Hedge Funds?

http://www.planethedgefund.com/hedgeqa/questionpages/q3.php3

 

IMF: International Monetary Fund: Hedge Funds- How Much Do We Really Know?

http://www.imf.org/external/pubs/ft/issues/issues19/

 

“Hedge Funds With Style,” by Brown and Goetzmann

http://www.nber.org/papers/w8173.pdf

 

ICI: Issues in Mutual Fund Legislation and Regulation: The Differences Between….

http://www.ici.org/issues/diff_mutual_hedge_fund.html

 

Penn State Smeal College of Business

http://www.smeal.psu.edu/faculty/huddart/OptionGlossary
/InvestmentCompanyAct40.shtml

 

Investorwords.com

 

Legg Mason Funds

http://www.leggmason.com/funds/

 

 

Descriptions of some basic hedge fund strategies by Fung and Hsteh:

“Market neutral funds refer to funds that actively seek to avoid major risk factors, but take bets on relative price movements utilizing strategies such as long–short equity, stock index arbitrage, convertible bond arbitrage, and fixed income arbitrage. Long–short equity funds use the classic A.W. Jones model of hedge funds, taking long and short positions in equities to limit their exposures to the stock market. Stock index arbitrage funds trade the spread between index futures contracts and the underlying basket of equities. Convertible bond arbitrage funds typically trade the embedded option in these bonds by purchasing them and shorting the equities. Fixed income arbitrage generally refers to the trading of price or yield along the yield curve, between corporate bonds and government bonds of comparable characteristics, or more generally between two baskets of similar bonds that trade at a price spread.” [Fung and Hsteh, p. 319-320]

 

 

 

 

 

 

 

 

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