Mutual Funds Vs Hedge Funds: These two types of investment create different outcomes for investors. The structures are similar. For both mutual funds and hedge funds, the investor contributes to a fund, sharing ("commingling") her investment with other investors. A professional investment manager then invests that shared pool of capital ("fund") to achieve the investment objective of the fund. The investors participate in the investment performance of the fund, seeing a change in the capital value of their investment, as well as possibly a regular dividend depending on the fund's objective. The investor can realise her investment by eventually selling out, in accordance with the fund's rules. However, the similarities end there.
Essentially, a mutual fund is designed to be a sensible way to invest in a market, usually a stock market. It's well diversified, holding many securities, with a simple but common sense approach to investment. It will deliver more or less (the advertising will always stress "more"!) the return of the market in which it invests, and of course will deliver the same risk. If the market falls 10%, the mutual fund will also fall by a similar amount.
If as an investor, you intend to invest for the long term-decades, not years-then simple exposure to financial markets should work well for you. Similarly, if you have a strong belief in the near-term performance of a market, a mutual fund is an efficient way to express that belief. But you'll be in for as volatile a ride as the market. Most mutual funds are run by big investment companies, with broadly standard fees.
A hedge fund is designed to give consistent positive returns.That objective is not guaranteed, and you're highly unlikely to get the same small positive return each and every month. But a well-run hedge fund will likely have more positive months than negatives, and those positive numbers should be larger than the negatives ones. The resulting performance profile should be a lot less risky than a market investment (such as a mutual fund). Investors use hedge funds generally because of their lower risk profile compared with market investments.
To do this, however, is difficult and takes a great deal of skill. By definition, a hedge fund manager can't just invest in the market. She must either look for other types of investment, including derivatives such as options and futures, and unlisted securities; she will almost certainly use much more sophisticated research and investment techniques than a mutual fund manager.
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Hedge funds will often hold short positions, where they have sold an investment that they don't own, with the expectation that it will fall in value and thereby allow the manager to buy it ("close the position") at a profit. A hedge fund can "hedge", i.e. make an investment to offset the risk of another, and short positions are a valuable tool. Another common technique is arbitrage, holding comparable long and short positions with the expectation of extracting a profit from small price difference between the position.
Finally, hedge funds are much more heterogenous than mutual funds. In other words, each hedge fund is much more different from its peers than would be the case for peer mutual funds. This means that hedge funds can also be good diversifiers in a portfolio, adding non-correlated returns to the mix of investments.
Hedge funds are generally run by smaller firms, or as smaller units within big firms, with higher fees than mutual funds.
Hedge funds are generally used by professional, or sophisticated investors, who want returns without too much market risk, and understand the power of a well-diversified investment.
There are also differences in how the two fund types are marketed, for regulatory reasons. A mutual fund is designed for unsophisticated investors, is regulated as such, and can then usually be sold in smaller quantums, through "retail" channels such as banks. A hedge fund, due to its complexity, is usually restricted to more sophisticated investors, and is not normally regulated for sale through retail channels. Hedge fund investors typically invest using private banks, or directly, and with much larger quantums ($1 million minimum investment sizes are not uncommon).
(By Peter Douglas, Director, Chartered Alternative Investment Analyst Foundation (CAIA Foundation)