Knowledge is Power

Among several investment opportunities, mutual funds and hedge funds are two of the most popular, most misunderstood, and somewhat controversial.

With over 19,000 mutual and hedge funds looking for investors, one of these days you may receive a call, e-mail, a personal visit or letter pitching the merits of investing in these funds, if you have not gotten any yet.

Mutual funds and hedge funds share the same basic characteristics but have major differences. Knowing what they are will protect you from overly aggressive salespersons and help you tell the difference between promise and reality.

In recent months, the government has cracked down on mutual and hedge funds that engaged in questionable practices, mostly related to fees charged and the way fund size was used to manipulate the financial markets.

By investing your funds with mind and eyes open, you will better understand and reap the benefits these funds have to offer.

Mutual and Hedge Funds are Partly the Same

Mutual funds and hedge funds have three basic similarities:

• Pooled investments
• Invest in publicly traded securities, and
• Professional management

In a pooled investment, several investors put their money together and entrust this to a fund manager, who then invests it. The pooling of funds allows more people, especially those who may not have large amounts to invest or are afraid to invest alone, to own bonds and stocks.

Bonds are IOUs issued by governments or corporations, while stocks are certificates of partial ownership in a corporation.

Mutual funds and hedge funds can invest in publicly traded stocks and bonds in any corporation or government anywhere in the world.

A professional fund manager’s job is to make the fund earn a higher return compared to what investors themselves could do on their own. By using his knowledge of the financial markets and how various events like hurricanes, wars, and climate change affect companies and governments, he should be able to increase the fund’s value.

In exchange for his work, the fund manager collects a fee that is a small percentage of the total value of the investment fund.

The company selling the mutual or hedge fund prepares a prospectus, a document describing the fund’s management, investment strategy, risks, and costs. The prospectus may include the manager’s performance, comparing this with similar funds in the market.

But Very Different

Mutual funds and hedge funds are similar but have major differences.

• Entry. Mutual funds are for everybody, but hedge funds are for a few sophisticated investors only.
• Structure. Mutual Funds can be open-ended or closed. Hedge funds are mostly similar to closed-end funds.
• Share Price. A mutual fund share can be as low as a few hundred dollars, but hedge funds require millions.
• Strategy. Mutual funds are conservative, but hedge funds are aggressive.
• Liquidity. Mutual funds are traded in the market, so you can redeem, or sell your share to the company or to another investor when you need the cash. Hedge funds have lockout periods when you cannot sell your share.
• Risk. Hedge funds are riskier than mutual funds. You can lose all your investment. Mutual fund risk is lower, and normally you cannot lose everything.
• Returns. Hedge fund returns, to reward investors for higher risks, are higher than mutual funds, unless the hedge fund is wiped out, in which case your return is zero.

Mutual Funds

Most mutual fund buyers are not sophisticated investors and invest because:

• funds are available through a retirement plan like the IRA, Roth IRA, or 401(k)
• funds seem safer than individual stocks (they are)
• they were told that funds are the best way to diversify (true)
• brokers or investment advisers have talked them into it, or
• aggressive advertising convinced them

Many mutual fund investors do not like doing their homework, and therefore do not know what they are getting into. A prospectus, even a simplified one, intimidates them, and they probably do not read them carefully, if at all.

The next time a mutual fund salesperson approaches and lures you into investing, ask for the prospectus and study it. Here is what you look for.

Fund Structure: Open-ended or Closed-end

Mutual funds are registered investment companies that collect funds from investors – individuals like you and institutions like banks, pension funds, and insurance companies – and invest the funds in stocks, bonds, and money market instruments. The amount you invest determines how many shares you own.

Mutual funds can have two structures: open-ended or closed-end. The main difference between the two is that open-ended funds can accept new investors and issue more shares, while closed-end funds have a fixed number of shares.

In an open-ended mutual fund, the company is required to redeem outstanding shares at any time, upon demand, and at a price determined by the current value of the fund’s net assets, or the net asset value (NAV). There are over 10,000 mutual funds, accounting for investments of around $7 trillion from 83 million investors.

In a closed-end mutual fund, the company issues a fixed number of shares and uses the fund to buy and hold a fixed portfolio of stocks, bonds, or other securities. The fund has a stated date for termination, upon which investors receive their proportionate share of net assets. There are around 800 closed-end funds with total investments of $371 billion.

Open-ended funds are convertible to cash (more liquid) more easily than closed-end funds and have lower costs and fees. Returns of closed-end funds, however, may be higher because of the higher risk. Open-ended funds are safer investments.

Categories of Mutual Funds

There are six general categories of mutual funds.

Bond Funds invest only in bonds, which are IOUs, or debt, issued by companies or governments (municipal, state, federal, or another country). Bonds are debts issued with the promise of full payment in the future and a regular interest payment that is a fixed percentage, called the coupon rate, of the amount borrowed. A buyer of a bond is the lender while the bond issuer is the borrower.

General Equity (Stock) Funds invest in stocks, which represent part ownership, or equity, in corporations. The goal of stock ownership is to see the value of the companies go up over time. Stocks are categorized by their capitalization (or market cap), and come in three sizes: small, medium, and large. Funds invested in companies can be classified as large-cap, mid-cap, or small-cap funds depending on company size. Mutual funds may also be categorized by the type of stock bought and may be called "growth," "value," or a combination of the two, called "blend" funds.

Balanced Funds invest in a mix of stocks and bonds. A typical balanced fund may invest 50-60% of its funds in stocks and the rest in bonds and cash. It is good to know the distribution of stocks and bonds in a specific balanced fund to understand the risks and rewards of that fund. Stocks, which are riskier than bonds, give higher returns.

Global/International Funds invest in companies in other countries. International funds invest only in foreign companies, while global funds may invest in some U.S.-based companies in addition to foreign companies. In general, international funds are much more volatile than domestic funds, which means the returns can vary wildly up or down from day to day.

Sector Funds invest in one particular sector of the economy like oil, energy, technology, banking, r real estate. Sector funds are extremely volatile because events generally affect the same sector in similar ways. For example, a real estate boom increases the value of a real estate sector fund, while a collapse does the opposite.

Index Funds match the shareholding of a target index, such as Standard & Poor’s 500 Composite Stock Price Index (S&P 500) or the Shanghai Stock Exchange. Index funds differ from actively managed mutual funds in that they do not involve any stock picking by fund managers – they simply imitate the returns of the specific index.

Which of the six is a better investment? There is no simple answer, but knowing a few more features of mutual funds will help you arrive at an answer to the question.

Mutual Fund Features

There is no standard answer to the question of which mutual fund is a better investment because each fund has a unique way of handling risk. Some investors love risks, but others do not. “The higher the risk, the higher the return” is a basic tenet of investing. The next time you receive an offer that sounds “too good to be true” – you can get high returns for very low risk – it very often is.

Any buyer of shares in mutual funds, whether closed or open-ended, should be familiar with the features of a mutual fund: share price, volatility, asset size, cost, and turnover.

Share prices of mutual funds are affordable, which account for their popularity and growth. One can invest in a mutual fund share for as low as $500, making them popular in employer-sponsored defined contribution retirement plans.

Volatility measures changes in the market price. Since the fund’s shares are traded in the financial markets, and the fund invests in bonds or stocks that are also traded in the same markets, investor behavior influence buy and sell decisions that affect the share price due to the law of supply and demand. Demand pushes up share prices while supply brings them down. Any event that affects demand or supply affects the share price.

Asset Size is a feature emphasized by sellers, but this is not the most important indicator of the fund’s future performance. Based on several studies, a fund’s performance actually goes down with asset size because the larger the fund, the more difficult it is to manage. However, in the hands of a good manager, a bigger asset size may be good since it allows the fund to influence the market’s buy and sell decisions.

Cost is often the most important feature overlooked by mutual fund investors. Otherwise known as fees, these expenses have a significant effect on fund returns. Most investors do not know how much they are paying. The fund collects these fees – ranging from 0.1% to 2.0% of the funds invested – every year, whatever its performance. A study showed that funds charging 0.51% to 0.99% of Net Asset Value had higher returns than funds charging between 1.50% and 1.99%. Several expenses affect fund returns, and investors need to understand how each expense affects them.

Five types of costs

• Sales fee or load that may be payable at the time of investment (front-load) or when the investor exits from the fund (back-load). For example, a fund with a 5% load must earn more than 5.25% yearly just to break even. Some are no-load funds, but...
• Management fees take the place of the sales fee in a no-load fund, but these fees may be higher, although several no-load funds charge low fees.
• 12b-1 fee pays for advertising, marketing, and distribution. This fee, ranging from 0.25% to 1.00%, is supposed to help investors because, in theory, if more investors come in, shareholders would have to pay lower per-share operating costs.
• Brokerage costs are incurred when the fund buys and sells bonds and stocks in its portfolio. The more the fund manager trades, the higher the costs will be.
• Taxes paid by the fund, because buying or selling stocks and bonds may generate taxable capital gains. Taxes reduce the fund’s returns.

The prospectus should show clearly the costs that are deducted from the fund’s assets since these will reduce returns.

Turnover shows the percentage of a fund’s holdings (stocks and bonds in its portfolio) that change every year through buying and selling. Turnover is the gross proceeds from all sales divided by the total assets in the mutual fund. Mutual funds have an average turnover rate of 85%. If the turnover ratio is more than 100%, the fund manager does a lot of buying and selling, which incurs brokerage costs and brings down the fund’s returns.

Given these features, which mutual fund is the favorite of investors?

Most investors prefer index funds due to their low turnover, lower costs and, since these mimic the stock market, the best combination of moderate risk and market returns.

A final tip: Never buy mutual funds at the end of the year. Mutual fund distributions are typically given toward yearend, in November or December. Buying a mutual fund toward the end of the year may therefore incur a quick tax bill along with their fund shares. When buying a mutual fund, find out when it will make its end of the year distribution and only buy shares after that date.

Hedge Funds, Not for the Faint-Hearted

Hedge funds and mutual funds are partly the same and very different.

The two differ mainly in their investment strategy: mutual fund investors look for relative returns, while hedge fund investors pursue absolute return strategies.

Most mutual funds invest in a predefined style, such as “small cap value” or into a particular sector, such as the oil and gas sector. To measure performance, the mutual fund's returns are compared to a benchmark. For example, a fund manager will try to outperform the S&P 500 Index. If the mutual fund beats the index, even if only modestly, say the index is down 9% while the mutual fund is down only 6%, the fund's performance would be deemed a success.

Hedge Funds Actively Seek Absolute Returns Hedge funds are more active in investing funds to seek positive absolute returns, unmindful of the performance of an index or sector benchmark. Unlike mutual funds, which make only buy-sell decisions, a hedge fund engages in aggressive strategies and positions, such as short selling, trading in options, and borrowing to enhance the risk/reward profile of their bets.

The active trading strategy of hedge funds explains their popularity when the market is going down. In a rising (bull) market, hedge funds may not perform as well as mutual funds, but in a bear market, they do better than mutual funds because they hold aggressive positions. The absolute return goals of hedge funds vary, but "6 to 9% annualized returns regardless of market conditions" is ordinary.Hedge fund investors need to understand that the promise of pursuing absolute returns means hedge funds are more liberal with respect to registration, where they invest, liquidity and fees charged.

Hedge funds are not registered with the Securities and Exchange Commission. They avoid registration by limiting the number of investors and requiring that investors meet an income or net worth standard. Furthermore, hedge funds cannot solicit or advertise to a general audience, a prohibition that lends to their mystique.

Hedge funds are not as liquid as mutual funds and may be difficult to withdraw anytime. Most hedge funds have a lockout period when investors cannot remove their money.

Lastly, hedge funds are more expensive and a portion of the fees is based on performance. Typically, they charge an annual fee equal to 1% of assets managed (sometimes up to 2%), plus they receive a share – usually 20% – of the investment gains. Many hedge fund managers invest their own money along with the other investors of the fund and, as such, have a personal stake in the fund’s success.

Hedge Fund Mystique

Most hedge funds have well-guarded investment strategies. There are three broad hedge fund categories based on the types of strategies used:

Arbitrage or Relative Value Strategies

Arbitrage takes advantage of inefficiencies in prices of the same product. A simple example is a car that sells for $2,000 in one county but sells for $2,100 in the next county. An arbitrageur buys the $2,000 car and sells it in the next county for any amount between $2,001 and $2,099.

Hedge funds look for inefficiencies in stock, bond, or money market prices, buy where it is low, and sell where the price is high. Hedge funds use sophisticated instruments like options to lock in the selling price without taking on any risk.

Only a few hedge funds are pure arbitrageurs, but historical studies have proven that they are a good source of low-risk and moderate returns. Because price inefficiencies in financial markets tend to be quite small, pure arbitrage requires large amounts of mostly borrowed money. Arbitrage opportunities are also rare, and if a strategy is too successful, copycats enter the market and the advantage disappears.

Most arbitrage opportunities are not risk-free. These “relative value” strategies capitalize on very small price differences, for example, between a company’s stock and the bonds it issued. A hedge fund can make, or lose, money by predicting the upward or downward movements of stock and bond prices.

Event-Driven Strategies

These strategies take advantage of one-time events like the acquisition or bankruptcy filing by a company. Since these events bring down the company’s stock price, a hedge fund can short the company’s stock: sell it at the current (higher) price and buy the stock a few hours, or days, later after the announcement is made and the stock price has gone down. The same hedge fund can take opposite positions in the company being acquired or a company that is about to be reorganized, since these events usually increase the stock price. In the latter case, the hedge fund buys the stock at the current (lower) price and sells some days later once the price goes up.

Directional or Tactical Strategies

Most hedge funds use directional strategies, like the macro fund popularized by George Soros and his Quantum Fund. Macro funds are global funds that invest based on bets on currencies, interest rates, commodities or foreign economies. They are for “big picture” investors who do not analyze individual companies but prefer to bet on decisions of foreign governments. Directional strategy hedge funds are for sophisticated investors who trust the fund manager to know the way global events shape the way the financial markets will move in a country or region.

Though smaller than mutual funds, there are an estimated 8,350 active hedge funds with investments of $875 billion growing at about 20% per year.

Additional Information

This brief overview of mutual and hedge funds will not make you an expert. There are two private companies that give detailed information to help you make a more intelligent investment decision.

These companies monitor mutual funds and hedge funds in the market:

• Morningstar tracks the performance of mutual funds
• The Hedge Fund Association is an international not-for-profit association of hedge fund managers, service providers, and investors formed to unite the hedge fund industry and increase awareness of the advantages and opportunities in hedge funds.

External Links:

• Morningstar - Tracks 10,000 mutual funds
• The Hedge Fund Association - Private site on hedge funds