Hedge funds vs. Mutual funds
Many people here on WSO are obsessed with hedge funds and look upon the mutual fund industry with disdain. However, I have seen a lot of misinformation out there on what mutual funds even do, so I wanted to layout the basics of both hedge funds and mutual funds and what makes them similar and what makes them different. Also, I want to layout what some of the incentives are for some of the managers of these funds and how those incentives either align or don't with the investors. I'm not a lawyer, so don't take this as legal advice. This is just a general outline.
Back in the 1930's and before, pooled investment vehicles were not standardized which invited increased regulation which culminated with the Investment Advisers Act of 1940 and the Investment Company Act of 1940 (http://en.wikipedia.org/wiki/Investment_Company_Ac...). The former defines the fiduciary responsibilities of investment advisers and the latter describes the regulations of '40 Act funds (mainly mutual funds). Generally, both hedge fund and mutual fund managers need to be registered with the SEC as a Registered Investment Adviser. A Registered Investment Adviser can run both hedge funds and mutual funds, if they so choose and many do.
There is no legal definition of a hedge fund
Most hedge funds are set up as either 3(c)1 or 3(c)7 limited partnerships. The basic difference between these funds is that a 3(c)1 is limited to 99 investors and has an Accredited Investor standard (basically, $1 million net worth or $200,000 in income or $300,000 in income for a married couple) and a 3(c)7 fund allows for up to 499 investors and also has a Qualified Purchaser standard (basically a $5 million liquid net worth requirement and additional standards for institutional investors). Most funds go for 3(c)7 status so they can maximize the number of investors.
Whereas, in a mutual fund, basically anyone can own one.
Fees
As you all know, partnerships are allowed to charge virtually any type of fee they desire. Most hedge funds are partnerships that have settled on a management fee and an incentive fee. Mutual funds don't charge incentive fees. As one might expect, this can have a significant impact on the behavior of these managers, sometimes in unexpected ways.
Incentives by fund type
Everyone knows that good performance attracts assets. So, whether you are a hedge fund manager or a mutual fund manager, you seek to have good performance.
Incentives for mutual fund managers
Because mutual fund managers only receive a fee based on asset levels, the incentive is to gather as many assets as possible. This can be accomplished through strong performance, an effective sales force, differentiated offerings, advertising, brand, convenience, etc.
I'm not going to argue for or against EMH here, but one thing that is almost universally accepted is that a large asset base is the enemy of good performance.
Places like Morningstar rate the performance of mutual funds and make it easy to compare funds. The good or bad performance of a fund follows it for a long time. So, an incentive for a fund that has had good performance is to 'lock-in' that performance by becoming more like their index. One of the dirty little secrets of the mutual fund industry is that many fund companies will start a number of funds and manage them before making them available to the public. The reason this is important is because they can make available to the public only those funds which have strong performance. Once again, this good performance will help them attract assets and now they could become more index like and few investors will know because they will generally just see the longer track record.
This isn't to say that all fund companies do this, I am just laying out their financial incentives. An incentive for someone might also be to protect their reputation and if they have banked enough money, that may be more important to them than anything else.
Incentives for hedge fund managers
Because hedge fund managers receive both an asset based fee and a performance fee, their incentive is to find a balance between asset levels that they can continue to generate strong performance and a sufficient asset base to generate fees. For some funds, this level is relatively small, while for others it is virtually without limit.
In addition, most funds have a high water mark for performance. This means that if they have a bad year, they need to make up that ground before they can start earning an incentive fee again. The incentive here is not to take too much risk so as not to put your incentive fees at risk.
However, there are negatives to the incentives of hedge fund managers as well. The performance fee does present an element of heads I win, tails you lose, for the hedge fund manager. Let's assume there was a trade out there that had a 20% chance of gaining 1,000% and a 80% chance of losing 100%. A hedge fund manager might take this bet because if they lose, they just close shop; if they win, they earn 20% of the 1,000% (200%). One reason many investors ask hedge fund managers how much they have invested in their own funds is because they want to minimize this incentive to recklessly gamble with their money. However, you have seen enormous blow-ups in the hedge fund space (LTCM, Amaranth, etc.) that you just don't see in the mutual fund space, partially because of this incentive for hedge funds and partially because mutual funds don't really have the freedom to blow up like this because of their diversification requirements.
Summary of Incentives
While both types of managers have incentives that may not always be to their client's benefit, most people in the industry try to do the right thing. However, it's important to know their incentives, because whether it is conscious or not, bad incentives can negatively impact behavior, for at least some people.
Basic Description of Mutual Funds
Mutual funds are considered to be Registered Investment Companies (RICs). These are registered funds that need to comply with certain rules to maintain their tax status and remain available to the general investing public. There are several types of RICs:
1. Open end funds: these are the funds you are most likely familiar with. You can buy or sell these funds at the close at the Net Asset Value (NAV: the net value of all assets of the fund divided by the shares outstanding). Fidelity, Capital Guardian, T. Rowe Price are some examples of big fund companies.
Liquidity: Daily at the close
Share pricing: Trade at NAV with fund company
Leverage: usually none
2. Closed end Funds
Liquidity: During market hours you can trade your shares on the secondary market.
Share pricing: Done in the secondary market at the prevailing market price. Shares often trade at significant discounts or premiums to NAV.
Leverage: Most funds are levered, especially fixed income funds. Leverage often comes by issuing preferred stock.
Special note: Because the fund never really needs to meet redemptions, these funds can own can own illiquid investments.
Diversification Requirements: Mutual Funds
http://www.bbdcpa.com/blog/internal-revenue-code-d...
Here are the two big diversification rules for mutual funds:
1. The 50% Test: For at least 50% of the assets, you can't have more than 5% of the fund's assets in any one issuer. Exceptions are government securities and other RICs (usually money market funds, but could be another type of fund).
2. The 25% Test: No more than 25% of fund assets can be invested in one issuer (government securities exempted) or in publicly traded partnerships (usually MLPs).
Diversification Requirements: Hedge Funds
There really is no restriction for hedge funds.
Other reading:
http://www.kirkland.com/siteFiles/Publications/8D0...
At most, I've covered the tip of the iceberg on this topic, so feel free to add your comments here.
Comments
great info sirtrades, thanks
great info sirtrades, thanks
WSO's COO (Chief Operating Orangutan) | My story | Connect with me on Linkedin.
2013 WSO Conference
Very informative, I never
Very informative, I never actually knew that 3(c)7's existed. I always thought the only option was a 3(c)1.
I help people with the tough situation of not knowing how to respond to emails.
Awesome post.
Awesome post.
You have your way. I have my way. As for the right way, the correct way, and the only way, it does not exist. - Friedrich Nietzsche
Great article, thank you Sir!
Great article, thank you Sir! As generous as I can be, I will throw no more than 5K to the MF recommended by my friend and see if the fund will break its underperformance record in the new year.
The Auto Show
Good info. However, what he
Good info. However, what he says only applies to US funds. Mutual funds overseas are governed by the local jurisdiction and not subject to 40 act.
For instance, SICAV funds marketed across borders in Europe under the UCITS directive have a lot of other restrictions that distinguish them from typical 40 act funds.
Also, hedge funds based out of Europe will be governed by AIFMD starting mid this year, which will add some restrictions as well.
Point is, both mutual funds and hedge funds are going through a lot of regulatory changes in various places.
Fantastic, thanks for
Fantastic, thanks for sharing.
- V
Thanks for following through
Thanks for following through on that other thread and all the confusion there Sir. Would throw you an SB if I had one.
"Do not go gentle into that good night"
great post, would the OP mind
great post, would the OP mind to add how to break into mutual funds from a hf background. Also, would be great to hear more about lifestyle, money and career progression, etc. Thanks
bearcats: what he says only
what he says only applies to US funds.
That's a good point, thanks for bringing it up. Everything regulatory in this post is US only.
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
Ricqles: great post, would
great post, would the OP mind to add how to break into mutual funds from a hf background. Also, would be great to hear more about lifestyle, money and career progression, etc. Thanks
It probably depends on what kind of hedge fund you're coming from and what type of mutual fund you're going to and what position you have and you're seeking.
If you're coming from a L/S hedge fund, it should be easy to transition to an equity mutual fund. On the investment side, your day to day job will be very similar. Believe it or not, there are mutual funds that employ the following strategies:
- Long-short
- Merger arb
- Convert arb
There aren't a ton of them, but they exist. There are also plenty of go anywhere mutual funds that would probably take people from macro backgrounds. Global tactical allocation and global fixed income funds would probably look for people with macro backgrounds as well.
My old firm, which was a relatively large asset manager had both a centralized research group and a bunch of PM teams. The research analyst's pay ranged from about $250k to about $1 million, depending on experience and performance. The median was probably about $400-450k. The portfolio managers pay ranged from about $400k to $25+ million, mostly determined by assets and seniority on the team. The median was about $1 million. I know most people who give these estimates are usually just guessing, but I was in management there, so I would review the P&Ls, including comp for everyone on these teams/groups. So, these aren't my best guess, this is what was true at our firm a few years ago.
As far as lifestyle, the hours were usually about 8 am - 6 pm for most people; longer during earnings season. In other words, it was pretty sweet to be a PM there.
Career progression for most at our firm was not standardized at all. Many people came from research (either internally or externally) and then joined as a relatively junior PM. If they were good, they could either branch out on their own or wait for the old guy to retire. As you could imagine given the lifestyle, people didn't want to retire often.
Hope this helps.
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
would be good to expand on
would be good to expand on the effects diversification requirements and relative vs absolute performance have on holdings
that to me and aum raising vs performance are the largest differences
whatwhatwhat: would be good
would be good to expand on the effects diversification requirements and relative vs absolute performance have on holdings
that to me and aum raising vs performance are the largest differences
You want to take a stab at it? I would only note that not every mutual fund is relative performance focused, even though most are. There's nothing that requires them to be, it's really the consultants and Morningstar that cause most of them to be that way.
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
Interesting situation at a
Interesting situation at a mutual fund i know of, they are not benchmarked and do not pay attention to any index weightings or performance. This is all fine and good but in marketing meetings with institutions the analysts on that side simply randomly pick their own benchmarks to compare it to, so while they say they are non-benchmark, from a fund raising perspective they are benchmarked, they just don't get to choose the benchmark! The institutions/consultants will acknowledge that it doesn't make sense but they will say that is the best they can do. It is truly idiotic but that's the way it goes. Being absolute return as a mutual fund can be quite odd while fund raising.
Excellent post sirtrades!
Excellent post sirtrades!
Highly informative post,
Highly informative post, thank you OP. But I'm curious regarding the prestige level at HF's vis a vis MF's. Why is it so difficult to get into HF's as compared to MF's; and why are most HF managers held in such high regard as compared to MF managers?
READ MY BLOG: http://www.bateman-begins.blogspot.com
[Double post]
READ MY BLOG: http://www.bateman-begins.blogspot.com
Great post, and some great
"When you stop striving for perfection, you might as well be dead."
CAinPE: Highly informative
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
CAinPE, I think you are
Hedge funds : Good for
Great post, Sir. Appreciate
SirTradesaLot: Probably you
READ MY BLOG: http://www.bateman-begins.blogspot.com
SirTradesaLot: I have a
READ MY BLOG: http://www.bateman-begins.blogspot.com
What is the typical
Y2A: What is the typical
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
Y2A: What is the typical
There is a lot of money in
Let me explain to you how this works: you see, the corporations finance Team America, and then Team America goes out...and the corporations sit there in their...in their corporation buildings, and...and see, they're all corporation-y...and they make money
Keep in mind there's an
I hate victims who respect their executioners
Follow BH & Co. on Twitter: @DumbLuckCapital
twitter.com/DumbLuckCapital
BlackHat: Keep in mind
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
BlackHat: Keep in mind
KarateBoy: BlackHat: Keep
I hate victims who respect their executioners
Follow BH & Co. on Twitter: @DumbLuckCapital
twitter.com/DumbLuckCapital
BlackHat: KarateBoy: Blac
Double post
Great post Sir! Diceclay, do
Walkerr: Great post Sir!
Let me explain to you how this works: you see, the corporations finance Team America, and then Team America goes out...and the corporations sit there in their...in their corporation buildings, and...and see, they're all corporation-y...and they make money
Just because it's large
I hate victims who respect their executioners
Follow BH & Co. on Twitter: @DumbLuckCapital
twitter.com/DumbLuckCapital
Black Hat had a great point.
Let me explain to you how this works: you see, the corporations finance Team America, and then Team America goes out...and the corporations sit there in their...in their corporation buildings, and...and see, they're all corporation-y...and they make money
Any thoughts on exit opps
constipatedmonkey: Any
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
I must admit that I prefered
CNBC sucks
"This financial crisis is worse than a divorce. I've lost all my money, but the wife is still here." - Client after getting blown up
I would add that I do find
Financial Modeling Training
Guide to Finance Interviews
BlackHat: and honestly who
SirTradesaLot: whatwhatwhat
AndyLouis: great info
HFRX Equal Weight performance
Let me explain to you how this works: you see, the corporations finance Team America, and then Team America goes out...and the corporations sit there in their...in their corporation buildings, and...and see, they're all corporation-y...and they make money
SirTradesaLot: constipatedm
Smartmoney: SirTradesaLot:
Turbo leverage for capital explosion -- BD Capital
My WSO Blog
SirTradesaLot: Smartmoney:
Interesting discussion...all
Smartmoney: SirTradesaLot:
Turbo leverage for capital explosion -- BD Capital
My WSO Blog