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_Act_of_1940). 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-diversification-requir…
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/8D0C4590AF4DBA4630DCEA95…
At most, I've covered the tip of the iceberg on this topic, so feel free to add your comments here.
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.
CAinPE, I think you are confused. The idea that it is more difficult to get into a hedge fund vs a mutual fund is just not correct. They are both extremely difficult to get into. In my sector there are as many mutual fund analysts as hedge fund analysts and I can assure you there is no difference in the difficulty, if anything turnover is so much lower at the mutual funds that it is actually easier to get a hedge fund job. Another thing, i personally don't know a single person over the age of 30 at a mutual fund trying to get a hedge fund job. A mutual fund is typically part of a larger organization which often times equates to more stability. Even the largest hedge fund is typically owned by no more than a few people, think of a hedge fund as working for an internet startup up with all of the uncertainty while working for a mutual fund is like working for a fortune 500. While an Analyst is probably going to make $200-1 million at a mutual fund very, very few hedge fund analysts are going to make more than that and if they do it is quite possible they are taking massive beta risk which means their fund can collapse at any time. Hedge fund managers are held in high regard in the media because they make an enormous effort to be in the media as often as possible, think about Ackman and HLF, how many times has a Fidelity manager invited hundreds of media outlets to a stock pitch? It doesn't happen. Also, how often is the number ten guy at a fortune 500 held up as a star in the media? Name the number 10 guy at Cisco or Microsoft, the person is still worth tens of millions of dollars most likely yet we don't know who it is. This simply goes back to a hedge fund being like a startup and a mutual fund being like a fortune 500 company.
If you had two kids and a wife that didn't work and someone offers you 500k per year with virtually no volatility in your earnings or the outside chance to make 1-1.5 million or lose your job every year at a hedge fund, most people will take the steady job where you will still be rich over time. Also keep in mind that just because a hedge fund is high profile and has high AUM doesn't necessarily mean every Analyst there is making millions of dollars in a good year. Unless your contract specifically states a quantitative formula for your compensation a great year for your hedge fund does not always equate to a great year for an Analyst. There are a number of old threads of hedge fund analysts complaining about their poor pay in a great year. The best quote i've read on WSO is "A hedge fund is designed to make one person a billionaire while an investment bank is structured to make thousands of people millionaires" This is applicable to the hedge fund vs mutual fund debate as well.
When i go to industry conferences the "new" guys are always from hedge funds while the people you see year after year are the mutual fund guys, most are making $300-$400k while very senior analysts and PMs are making seven figures, working 8 to 6 at the most and having a great life. I only know a few hedge fund guys who i see year after year at industry conferences, everyone else gets blown out over time. Hope that helps.
I hate threads like this. A lot.
If you work in solid groups at GS/MS/JPM/EVR/GHL/LAZ/MOE/BX/etc. and you do a good job you'll get a chance to interview.
If you work in solid groups at BAML/Citi/etc. and you do a good job you will also get a chance to interview.
I personally don't think that firms would ever hire someone JUST because of their group - I think the reason you see pockets/concentrations from certain groups/banks can largely be attributed to self-selection (e.g. The best people join the best banks and groups, and those same best people perform the best in interviews).
Again, I tell kids that ask me not to look at things in terms of exit ops. Look at things in terms of interview ops. And if you do a good job at a solid bank/group and you impress headhunters, you will get interviews. From there on it's all up to you. If you you don't work at Blackstone or Morgan Stanley or Goldman or J.P. Morgan or wherever you kids have convinced yourselves you need to work these days YOU WILL BE OK.