Hedge funds and mutual funds are similar, as they both pool large sums of money from many investors to create a managed fund for investment. Both funds spread the risk with a diverse portfolio, but there is one significant difference. Almost anyone with $1000 can invest in a mutual fund, but only investors with a high net worth certification have access to hedge funds.
Mutual funds can invest in publicly traded hedge funds. The average investor cannot directly invest in hedge funds, but he can buy into a mutual fund investing in hedge funds, and reap the benefits and rewards of hedge funds without the initial investment that comes with them.
Inexperienced investors should be aware of the other differences before adding hedge funds to their mutual fund holdings. Some differences are positives, and some are negative, so we’re going to explore them further and highlight key factors to consider before turning loose of your money.
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Table of Contents
Why Would We Want Hedge Funds in Our Mutual Fund Portfolio?
The quick answer to that question is that hedge funds outperform mutual funds.
The primary reason to invest in anything is to get your money working for you to make more money. Hedge funds are not closely regulated, which adds to the risk and frees investors to use investing strategies that regulated mutual funds would not use.
The hedge funds can realize huge returns, but they come at a comparably large risk. An investor must be experienced and able to withstand the loss, which is why the Securities and Exchange Commission mandates that all hedge fund investors meet that high net worth of at least $1 million.
Many hedge funds are privately managed and never available to the general public.
Assets that can turn a hefty profit are management choices for hedge funds. That’s why mutual fund managers will select a publicly traded hedge fund to add to their portfolio, as it has the potential for a significant return while managing risk.
Mutual fund investors will not realize as great a return as the direct hedge fund investor will. However, their risk and fees are smaller.
Hedge Funds Tend Toward Non-Liquidity
Investments held in mutual funds can be traded daily, so they are referred to as liquid. Hedge fund investments are usually held much longer, but they sell less frequently, such as monthly, quarterly, or even yearly.
Hedge fund investments are considered alternative investments and illiquid, while some are leveraged with borrowed capital.
Alternative Investments might include:
- Art
- Real estate
- Commodities
- Insurance products
- Foreign currency
- Private equity
- Distressed securities
Not only are Hedge Funds lightly regulated but often opaque and easily scrutinized. Such unique factors add to their attraction for many.
Mutual Funds include:
- Stocks
- Bonds
- Cash
These funds are transparent and regulated. Managers file public reports with the SEC.
The attributes that make hedge funds, mainly privately held hedge funds, so lucrative and desirable, are the same qualities that lend themselves so easily to investment fraud. There is light regulation and an opaqueness that is difficult to scrutinize,
Why Would a Hedge Fund Choose To Be Publicly Traded?
We wonder why a hedge fund would choose to be publicly traded when its primary purpose is to maintain a higher rate of return regardless of market fluctuations. Hedge fund managers usually prefer the anonymity and less government red tape that comes with fewer regulations.
Let’s take a closer look at some of these reasons.
- Many large funds are diversified and publicly offered, so their hedge funds are traded in addition to mutual funds.
- Their exposure is minimal, and their investment firm is already well equipped to handle the government paperwork.
- Offering hedge fund opportunities to outside investors brings in capital and generates name recognition for their other funds.
Invest in Hedge Funds Through Your Mutual Fund
When you select mutual funds for your investment portfolio, either on your own or with a fund manager, read the prospectus of each stock or bond. Familiarize yourself with the value and performance history and projections.
Your strategy will be different when selecting a hedge fund for your mutual fund portfolio. The same information may not be available, and performance may be more volatile than mutual funds.
The hedge fund manager is key to the funds’ profitability, so you need to research the fund managers, including their strategies, average rate of return over the long term, and risk factors.
You’ll need to know what the fees will be. Hedge fund managers, on average, operate on a 2% management fee and 20% incentive fee. These fees are based on the amount of capital managed, and the incentive fee is based on year-end profits.
Your hedge fund fees might be in addition to your mutual fund management fee.
If your mutual fund and the hedge fund are under the same investment corporation umbrella, you may not have fees on fees.
Mutual Funds Allow Small Investors Opportunities
If you don’t have the funding to invest in hedge funds, mutual funds might be your only option to getting into the bigger opportunities. Let’s look at some of the options available to you as a small investor.
- Mutual funds can provide opportunities for small investors that they might not otherwise have. Being able to invest in hedge funds is one example of that, and if you can stand the risk, you could even have a mutual fund of hedge funds.
- If researching and picking stocks, bonds, money market funds, hedge funds one by one to add to your investment portfolio makes your eyes cross, then choose a managed mutual fund. You can diversify according to your short-term and long-term goals.
- You can follow your investments by watching your chosen mutual fund instead of following each acquisition individually. It’s the overall return that is of interest. Your manager will deal with buying and selling to keep the fund profitable.
- Investing for retirement, college, or generating income could not be more straightforward. The fund you select will have an initial cash investment requirement. That amount could be as little as $1000 or as high as $10,000.
- After that, you can make monthly deposits, so your investment increases according to the schedule you have set. Or, you can save up and buy more shares.
- Some companies offer dividends to their stock investors, which can be reinvested.
- Your mutual fund investment is liquid, which you can trade or sell at any time.
Should Hedge Funds Be Part of Your Mutual Fund?
Not everyone is a proponent of investing in hedge funds and disagrees with making them available to small investors whose goal is to secure their financial future. Hedge Funds, creatively managed, make money whether the market is up or down.
The strategies used to achieve this are not always transparent. Since the hedge funds are so loosely regulated, transparency, rate of return, and losses are not always a matter of record.
The lack of regulation allows a climate where fraud and conflict of interest can easily take root.
An article written several years back for the Harvard Business School publication “Working Knowledge” by D. Quinn Mills, Professor Emeritus of Business Administration, seems relevant today. (Link in the article sources below)
Professor Mills draws attention to traditional conservative banks’ practice of accepting clients’ money to be managed by their mutual fund.
The client has every reason to assume he has invested in a low-risk fund and may not be aware when the banks turn it over to hedge fund managers as part of their fund of funds. The risk and the high fees revert to the small mutual fund investor.
In various investor publications, published by the Security and Exchange Commission, you will find concise information regarding the practice of mutual funds of hedge funds, including:
- The risks presented by hedge funds.
- Warnings about layers of fees.
- Examples of manager misconduct, Ponzi schemes, and other fraudulent activity.
- How-tos for researching mutual funds and their managers before investing your money.
You will find valuable information that will help you make wise investment choices.
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Conclusion
If investments did not carry a degree of risk, they would have little value. The investor has to take the time and carry out his due diligence before selecting a managed fund. A wise selection will factor in your investment goals and risk tolerance.
Adding a hedge fund to your mutual fund is the one way the average investor can participate in more volatile but high-return investments.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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