Hedge
Funds versus Mutual Funds
Mutual Funds
Mutual funds are actually investment companies, that
is, they are firms that collect investments from investors
and professionally invest money on behalf of investors.
Investment companies collect fees from investors,
usually drawn directly out of the investment, as a
fee for the service of investment. There are primarily
three types of fees an investment company will charge:
Up-front fees: these are fees charged for the collection
of assets. In the world of mutual funds, these are
often known as sales loads.
Management fees: these are fees charged for the on-going
service of investing assets.
Performance fees: these fees are a "cut"
of the profits of investing. Performance fees are
assessed on the "upside" portion of the
fund value, that is, on the portion of the value of
the fund due to investment return. For example, if
an investor invests $100 in a fund and the fund value
rises to $120, then a performance fee may be charged
on the $20 upside.
Mutual funds come in two varieties: closed end and
open end. Open end mutual funds are investment companies
that continually offer new shares of the fund to the
public for investment and stand ready to redeem outstanding
shares at the net-asset value (NAV) of the fund. In
this sense, the company is the unique market maker
of shares in the company. They will sell or buy the
shares every day. Mutual funds sell their shares at
the fund net-asset value per share, which may be regarded
as the value of the investment in the fund. It is
calculated by taking the value of all investments
in the fund less any liabilities (such as fees) divided
by the total number of outstanding shares.
Mutual funds are regulated investment companies. In
particular, they are regulated by the Investment Company
Acts of 1940 and 1970. The 1940 Act regulates certain
aspect of a fund's operations including financial
statements, investment goals, personnel, debt, and
managers. The 1970 Act regulates sales charges (i.e.,
sales load and in particular the maximum sales load)
and fees of mutual funds. The main point that concerns
us in this lecture is that mutual funds are tightly
regulated entities, a fact which is not the case for
hedge funds.
Note that open end mutual funds cannot be traded in
a secondary market. Their values are determined by
the investment company (mutual fund company) and the
company is required (by the Act) to buy and sell the
shares of the company at the NAV. Two key pieces of
terminology concerning all funds are:
Inflows: this is the flow of money into a fund
Outflows: this is the flow of money out of a fund
Closed-end mutual funds unlike open end funds are
traded in a secondary market. Such funds are distinct
from open end funds and work as follows. The fund
issues a limited number of shares and does not redeem
the shares. Rather, the company publishes information
about its NAV and the shares are traded on a secondary
market or through an over-the-counter market. In this
sense, investors purchases shares of closed end funds
much in the same way they purchase shares of stock
and for similar reasons. An important feature of closed
end funds is that their market values and net-asset
values may differ. This is because the net-asset value,
determined by the value of the investments in the
fund, may be different than the value (per share)
that investors are willing to pay for the fund. A
closed-end fund whose market value is less than its
NAV is said to be trading at a discount.
Hedge funds, unlike mutual funds, are not able to
stand ready to buy and sell shares on any given date.
Rather they have two forms of liquidity constraints
that they impose on investors:
Liquidity dates
Lockup
Minimum investment
Credit should be given to Neil
A. Chriss as some of these references are a compilation
from a lecture series.
