Hedge Funds and Mutual Funds

Episode #8 of the course Introduction to capital markets by Doha Soliman, CFA

Welcome back! We have much to cover today, so let’s get started.

Hedge funds are another alternative investment that, like most of their kind, have very specific requirements for entry. Essentially, they are limited partnerships that gather investments from individuals and invest them in specific instruments, such as equity or bonds. Like most alternative investments, they are not traded on an exchange and can be rather exclusive. As they require large initial investments and may have lock-up periods of several years, they tend to attract wealthy investors.

Hedge funds utilize sophisticated strategies to generate high returns. However, unlike publicly available funds such as mutual funds (we’ll talk about them later in this lesson), they do not have to publicly report their earnings or returns and are therefore difficult to compare to other funds in terms of return profiles.

Hedge funds have a variety of strategies they utilize. A strategy refers to the main platform the fund managers use to make trade decisions. Let’s take a look at a few of the most common ones:

Long/short equity. Fund managers utilize a combination of long and short positions to offset their risk (beta) and increase their return (alpha).

Distressed debt. Fund managers trade in the debt and equities of corporations in financial distress.

Arbitrage. Fund managers exploit price differences between equities and trade them accordingly.

Event driven. Fund managers assess corporations undergoing corporate events (mergers, takeovers, etc.) to determine which stocks to trade.

Global macro. Fund managers utilize directional assessments of global and political issues to determine which stocks to trade.

Mutual Funds

Since we discussed hedge funds, it may be useful to discuss another common type of funds: mutual funds. Like hedge funds, mutual funds consist of fund managers who pick stocks and actively manage a portfolio in which you get to buy shares. Mutual funds, however, are considered to be traditional investments and are publicly traded long-only funds. Also, they are restricted to trading in equity and bonds only, while hedge funds can invest in any financial instrument.

Like all publicly traded investments, mutual funds are highly regulated and have strict reporting requirements. They are priced once a day only, as their price doesn’t fluctuate. Mutual funds can be bought in brokerage accounts online or through a broker, and they have high liquidity and thus, can be sold the very next day. Unlike hedge funds, mutual funds do not have lock-up periods and no minimum investment.

As we see the difference between hedge funds and mutual funds, it is easy to see why mutual funds are more common and a more reasonable option for novice investors.

Tomorrow, we’ll discuss real estate and the different ways investors can have access to it as an investment.

Recommended book

Hedge Fund Market Wizards: How Winning Traders Win by Jack D. Schwager