Hedge funds versus mutual funds
By nature, hedge funds are more aggressive than mutual funds although they share some common attributes. An investor in a hedge fund is willing to take higher risks than the mutual fund investor.
Both hedge funds and mutual funds invest from a pool of investible funds. They also trade in publicly traded securities. The similarities end here.
OWNERSHIP AND REGULATION
Hedge funds are by and large unregulated entities because they are privately-owned unlike mutual funds which are owned and sponsored by public corporations and hence answerable to their owners and the market regulator. It is because they are not registered with the regulator that they are not bound by investment or disclosure norms. As they are free to devise their strategies in their pursuit of absolute returns which could be much higher than the average market returns.
Hedge funds limit the number of their investors to circumvent the registration requirement of the market regulator and because they are not allowed to advertise in the public domain they remain a club of hard-boiled investors trade high risks for super normal returns!
Hedge funds are less liquid than mutual funds because hedge fund investors are not allowed easy exit for a specified period. Liquidity provisions may vary from fund to fund but as a rule there are more constraints on exit for a hedge fund investor. Like it happened in the third quarter of 2008, hedge funds can put barriers to heavy redemptions by limiting the amount an investor can withdraw in one sale application.
Like in any mutual fund, the faithful investors or those who choose to stick with a fund are the ones who suffer the pains of a shrinking corpus in times of distress. This is precisely the reason why exit loads are in place to make exiting investors pay a price for leaving a fund. There is a section which believes that liquidity provisions of hedge funds should be diluted to pre-empt longer term investors from making an exit out of fear, and thereby precipitating a crisis, of being last in the queue for redemption in adverse market conditions like we witnessed last year.
Hedge funds have a more flexible investment policy than mutual funds, not allowed to freely short sell, leverage through derivatives or make concentrated investments in a sector or company. This gives hedge funds a head start in falling markets as they are able to hedge positions in the cash markets against exposures to futures and options besides other investment opportunities be it real estate, commodities or bullion.
The hedge fund industry controls over $1 trillion in assets according to some estimates (Source- The Economist, “Why Investors Should Fuss About Hedge Fund Fees,” November 16, 2006). It is because of their potential to generate above-average returns, high net worth investors and institutional investors make a beeline for hedge funds. As for professional fund managers they are sucked into the whirlpool of hedge funds because they get incentives on profits earned on top of the rewards on their own investments in hedge funds.