Set out the main ways in which hedge funds differ from mutual funds.
The idea
Hedge funds are pooled vehicles like mutual funds but differ in regulation, investors and freedom. Mutual funds are heavily regulated, sold to the public, must disclose holdings and fees, usually redeem daily at NAV and face limits on leverage, short selling and derivatives. Hedge funds are sold by private placement to wealthy or institutional investors, face much lighter regulation and disclosure, and can use leverage, short positions, derivatives and illiquid assets. They restrict liquidity through lock-up periods, notice periods and gates, which lets them hold positions that could not survive daily redemptions. Fees are higher and include an incentive fee on profits, whereas mutual funds charge an expense ratio on assets. Hedge funds target absolute returns, while mutual funds are usually judged against a benchmark. The common error is to assume hedge funds are entirely unregulated. The exam point is the list of differences.
A practice question
Which of the following is a typical feature of hedge funds that distinguishes them from mutual funds?
- They are sold by private placement to wealthy and institutional investors and face lighter regulation and disclosure. - correct
- They must publish their holdings daily and redeem shares at NAV every day.Why not: Describes mutual fund obligations, not hedge funds.
- They are prohibited from short selling or using derivatives.Why not: Hedge funds are free to use shorts, derivatives and leverage; limits apply to mutual funds.
- They charge only a small expense ratio and no performance fee.Why not: Hedge funds typically charge an incentive fee on top of a management fee.
Hedge funds are privately placed, lightly regulated and disclose little, while mutual funds are publicly offered, regulated and transparent.
A harder one
Which difference in disclosure and oversight between a mutual fund and a hedge fund is correct?
- Hedge funds must file the same prospectus and holdings reports as mutual funds.Why not: Private placement exempts hedge funds from most public disclosure.
- Hedge funds are regulated more strictly because they use leverage and derivatives.Why not: The reverse holds for the funds themselves: lighter rules apply, which is why leverage and derivatives are available.
- Neither type of fund is subject to any regulation.Why not: Both are subject to some regulation, and mutual funds to a great deal.
- Mutual funds are subject to extensive registration and reporting rules; hedge funds, sold privately, have far fewer obligations. - correct
Public offering brings registration and disclosure, along with limits on leverage and concentration. Private placement to sophisticated investors lets hedge funds disclose less and invest freely.
The hardest tier
An arbitrage fund holds positions that may take months to converge and could show large mark-to-market losses before they do. Why is a hedge fund structure better suited to this strategy than an open-end mutual fund?
- Hedge funds are required to hold more cash than mutual funds, covering any redemptions.Why not: Hedge funds have no such cash requirement; the advantage is a restriction on redemptions.
- Mutual funds must hold only convergent trades and cannot hold arbitrage positions of any type.Why not: Mutual funds can hold arbitrage positions, but their daily redemption forces them to stay liquid.
- Lock-ups and notice periods let it hold the positions through losses without forced selling to meet redemptions. - correct
- Hedge fund NAVs are guaranteed not to fall.Why not: No such guarantee exists.
Daily redemption exposes a mutual fund to runs when losses appear; hedge fund lock-ups give permanent capital for positions that need time to converge. Leverage and shorting limits also constrain mutual funds.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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- Tell apart exchange-traded funds (ETFs), closed-end mutual funds and open-end mutual funds.
- Recognise and outline the trading behaviours at mutual funds that are undesirable.
- Describe how an open-end mutual fund's share price is linked to its net asset value (NAV).
- Determine what a hedge fund investment returns, and describe how the fund's incentive fee is set up, with reference to the hurdle rate, high-water mark and clawback.
- Name the risks hedge funds run and describe their strategies, which are managed futures, global macro, emerging markets, fixed income arbitrage, convertible arbitrage, merger arbitrage, distressed securities, dedicated short and long-short equity.
- Outline the performance characteristics of mutual funds and hedge funds, and describe how measurement biases distort the assessment of performance.