Mutual funds are familiar to many people, but unless you work in finance, hedge fund are probably more of a mystery. If you've ever wondered about hedge funds or whether they might work for you, read on to learn more about this enigmatic investment.
Regulation
There have been rumblings about making hedge funds register with the Securities and Exchange Commission (SEC), but as of yet, the single biggest difference between mutual funds and hedge funds is that mutual funds are highly regulated. In the U.S., mutual funds and mutual fund companies are regulated by the SEC under the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisors Act of 1940. Hedge funds, on the other hand, bypass regulation by structuring themselves to be exempt, although they are subject to antifraud standards.
When a hedge fund employs leverage, it borrows money to achieve a higher return. If it can achieve an average return (the numerator) on a smaller capital base (the denominator), simple division dictates that it amplifies its rate of return. It's the same thing that happens when an individual buys stock on margin in a brokerage account. Leverage can also be employed by entering "cashless" derivative transactions. This is extremely common in all types of hedge funds. With a derivative, you don't have to employ all your cash to command a large notional amount. This way you can invest and earn returns greater than if you had to invest all of your cash in just stocks or bonds. Using leverage affords you higher returns, but also involves higher risk, as leverage works on both the up- and downside - it amplifies gains and losses. This is why hedge funds are often categorized as higher risk/higher opportunity investments, and why you hear about hedge fund blow-ups in the media. If a fund is highly levered and the market doesn't move in a favorable way, the fund can lose a lot of money very quickly. How Hedge Funds Can Achieve Higher Returns
Leverage isn't the only way hedge funds can achieve higher returns versus mutual funds; hedge funds also have the power to go short. Therefore, hedge funds should be able to make money in down as well as up markets. Traditional mutual funds are open to more systematic risk, as they can only be long on a position. If the mutual fund manager doesn't like a particular company or sector, he or she can choose to not buy that company's stock, but the fund manager can't short it and make profits as the stock price declines. By picking and choosing the right companies in which to invest, a traditional mutual fund can still beat its benchmark, but it might be harder to make money in a bear market.
Mutual funds are familiar to many people, but unless you work in finance, hedge fund are probably more of a mystery. If you've ever wondered about hedge funds or whether they might work for you, read on to learn more about this enigmatic investment.
Regulation
There have been rumblings about making hedge funds register with the Securities and Exchange Commission (SEC), but as of yet, the single biggest difference between mutual funds and hedge funds is that mutual funds are highly regulated. In the U.S., mutual funds and mutual fund companies are regulated by the SEC under the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisors Act of 1940. Hedge funds, on the other hand, bypass regulation by structuring themselves to be exempt, although they are subject to antifraud standards.
When a hedge fund employs leverage, it borrows money to achieve a higher return. If it can achieve an average return (the numerator) on a smaller capital base (the denominator), simple division dictates that it amplifies its rate of return. It's the same thing that happens when an individual buys stock on margin in a brokerage account. Leverage can also be employed by entering "cashless" derivative transactions. This is extremely common in all types of hedge funds. With a derivative, you don't have to employ all your cash to command a large notional amount. This way you can invest and earn returns greater than if you had to invest all of your cash in just stocks or bonds. Using leverage affords you higher returns, but also involves higher risk, as leverage works on both the up- and downside - it amplifies gains and losses. This is why hedge funds are often categorized as higher risk/higher opportunity investments, and why you hear about hedge fund blow-ups in the media. If a fund is highly levered and the market doesn't move in a favorable way, the fund can lose a lot of money very quickly. How Hedge Funds Can Achieve Higher Returns
Leverage isn't the only way hedge funds can achieve higher returns versus mutual funds; hedge funds also have the power to go short. Therefore, hedge funds should be able to make money in down as well as up markets. Traditional mutual funds are open to more systematic risk, as they can only be long on a position. If the mutual fund manager doesn't like a particular company or sector, he or she can choose to not buy that company's stock, but the fund manager can't short it and make profits as the stock price declines. By picking and choosing the right companies in which to invest, a traditional mutual fund can still beat its benchmark, but it might be harder to make money in a bear market.
Source:Investopedia