Hedge Funds vs. Mutual Funds

Mutual funds can represent a tempting idea for a lot of investors who do not have the means to either trade their accounts themselves or hire someone else to do it for them. There’s no question that mutual funds have provided a great many individual investors with the ability to obtain professional management without the usual requirement of having a large portfolio to make this worthwhile.

With the ability to pool their resources with other similar minded investors, this allows for the collective size of their assets to become very significant indeed, in the billions to even hundreds of billions with the largest ones. This is way more size than is needed to allow for professional management, and this therefore becomes a non issue.

Hedge Funds vs. Mutual FundsThere are also many investors who could afford dedicated portfolio management who choose to invest in mutual funds, as there are economies of scale involved. This is all about net return, or at least should be, and costs to manage a portfolio come straight off one’s returns, or add to negative returns, as the case may be.

Mutual funds do offer economies of scale, where the huge amounts of funds under management that they handle will usually allow them to charge management fees at a lower percentage than someone managing a lot smaller portfolio.

If we imagine a manger handling a billion dollars and one handling just a few million, the manager needs to get paid for his or her time and efforts, and therefore with the smaller portfolio we may expert that he or she will need to charge a higher percentage per year.

This is even more the case with passively managed funds, where less effort and decision making is involved, and all that needs to be done is maintain the desired proportion of the holdings of the fund, looking to mirror an index for instance.

Mutual funds therefore are about managing money efficiently, as well as providing professional decision making if the fund is being managed actively. For those investors without access to professional management or the ability to manage their funds themselves, or at least the belief that they do not have the ability, mutual funds can be a tempting option.

Mutual funds have become so popular that for many investors, they appear to be the only real option, where the decision becomes not whether one should invest in a mutual fund, but which ones to invest in.

The Challenges of Mutual Funds

The biggest challenge by far with mutual funds is its complete bias to the long side, meaning that it is only focused on buying and holding financial assets, stocks and bonds, and is therefore only equipped to benefit during bull markets.

Historically, prices of stocks have moved forward, in the very long term anyway, although in the short to merely long term, performance tends to be cyclical. We experience both bull markets, where stocks increase in value during the cycle, as well as bear market cycles, where stock prices decline generally.

Some mutual funds focus exclusively on stocks, some hold bonds, and many hold both as a means of diversification and hedging. In all cases though, they are limited to the long side of things, depending wholly on advances in prices to advance their fund value.

This can work well if prices are actually increasing, but not so well during sideways and bear markets. Mutual funds are helpless in bear markets, as their objectives are to always be substantially invested on the long side, and the long side is the wrong side during bear markets.

Some investors may think that active professional management can be sufficient enough to overcome losses during bear markets, where the stock market itself experiences a significant decline, but the truth is that most mutual funds underperform the market in spite of their active management, so this is no real help.

If one only sees the value of their portfolio decline by the extent that the market declines, one is lucky, and in fact passively managed funds, which just track indexes, are becoming more and more popular, with the largest funds in the world these days being index funds.

Regardless of the type of fund one chooses, one is left unprotected in bear markets, and must bear the brunt of the decline. Mutual fund managers want us to think that this is the way to go, the wise choice, to willingly take whatever punishment the market dishes out, but whether or not we should is a much more open question.

Mutual funds are also limited to stocks and bonds and cannot take advantage of other forms of trading, such as derivatives and arbitrage. Regulations prohibit this as well as being on the short side of investments, betting something will go down in other words, and this together with the objectives of having almost all of their funds exposed to the long side serves to make mutual funds suitable for some market environments but not really suitable for others.

This does not mean that individual investors are forced to ride out bear markets in mutual funds, as one can move in and out of them as one pleases, but this does require at least some skill on the part of the investor, knowing when to enter and exit, and a lot of investors struggle with this and make poor decisions here, tending to hold on to their positions too long out of hope and a reluctance to book losses.

The Advantage of Hedge Funds

Hedge funds are not limited to just stocks and bonds or just the long side. Hedge funds are equipped to take advantage of any market conditions, and can adapt to both bull and bear markets.

Most investors, for whatever reason, hold a strong bias toward the long side, and don’t properly realize that it doesn’t really matter much whether something is trending up or down, as we can choose which side we’re placing our bets on.

This is a lot like the game of craps at a casino where the crowd is betting on the side of the shooter, and it’s even seen as distasteful by many to bet against the shooter, even though the odds are the same and there’s no real reason to think or play that way.

Even if the very long term trend may be up, this doesn’t mean that one should be limited to riding that trend, because along the way other trends will be experienced of a shorter duration, and can be taken advantage of.

When you are on the wrong side of a trade for a period of time, even years, you experience a loss, and if you can gain instead of losing during this time, by being short the asset instead of long for instance, you can gain from this.

Individual traders and investors have the means to choose their trades, whether they want to be long or short, whether they want to trade assets other than stocks or bonds, futures or currencies for instance, or whatever else they choose, but with mutual funds, there is only one choice, the one the fund is limited to.

Being limited to being long the stock and bond market just doesn’t limit potential return, it also increases risk, and risk here is the risk that your portfolio will decline in value. If one is fully exposed to bear markets, one becomes subject to the full risk of the market.

Actively managed mutual funds will move in and out of assets in accordance with their expectations, but this is just a matter of being long one asset versus another, and even their proportion of hedging with bonds is prescribed. Mutual funds, whether passively or actively managed, are simply not in a good position to manage risk very well, in spite of what they might want us to think.

Hedge funds, on the other hand, are well capable of this, to the fullest extent possible in fact. Whether or not a particular hedge fund practices sound risk management is another matter, and they also have the means to take on even more risk than mutual funds do should they choose.

How Mutual Funds and Hedge Funds Stack Up

There have been some stories of hedge funds collapsing, and some managers have not practiced sound management, and the way that hedge funds are structured actually encourages managers to pay much less attention to risk management than they should.

Hedge fund managers make most of their money from taking a cut of the profits, without having to share in the losses. This can lead to a hedge fund being more aggressive then they should, getting into positions that are too risky, and this has resulted in massive losses at times.

There are some that want us to believe that hedge funds are therefore riskier by nature than mutual funds, due to their aggressiveness, but this is not the case generally. Hedge funds in general not only significantly outperform mutual funds, they also do so with less volatility, less risk in other words.

Hedge funds also tend to attract the best talent, due to the fact that so much more money can be made managing a hedge fund than a mutual fund, due to the much higher fees that hedge funds charge.

Where it is typical for one to pay a 2% management fee with a mutual fund, hedge funds charge this plus a percentage of the gains they produce, typically 20%, although some charge almost 50%. There are some hedge fund managers who make over a billion dollars a year on average just from these fees. On average, they are much better compensated than their mutual fund counterparts, so it’s not surprising that the really skilled ones are in the hedge fund business.

Perhaps the biggest difference between hedge funds and mutual funds is that while anyone can purchase a mutual fund, hedge funds are limited to investors of significant financial means, in terms of income and net worth, and the relatively high account minimums alone exclude many investors.

Hedge funds also require more of a commitment, as one must hold them for certain periods prior to redemption, where with a mutual fund you can redeem them anytime. Hedge funds produce more and therefore can demand more from investors and they certainly do.

Hedge funds do have some distinct advantages over mutual funds to be sure, but if one is in a position to become involved with hedge funds, one must still be very careful in one’s selection of a hedge fund or funds, as they vary considerably both in terms of performance and risk.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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