Hedge funds and mutual funds are both “pooled” vehicles, but there are more differences than similarities. For instance, a mutual fund is registered with the SEC, and can be sold to an unlimited number of investors.
Most hedge funds are not registered and can only be sold to carefully defined sophisticated investors. Usually a hedge fund will have a maximum of either 100 or 500 investors. Mutual funds may advertise freely; hedge funds may not.
Other differences include:
- Flexibility – the hedge fund manager has fewer constraints to deal with; he can sell short, use derivatives, and use leverage. He can also make significant changes to the strategy if he thinks it is appropriate. The mutual fund manager cannot be as flexible. If he changes his strategy, he will be accused of “style drift”.
- Paperwork – a mutual fund is offered via a prospectus; a hedge fund is offered via the private placement memorandum.
- Liquidity – the mutual fund often offers daily liquidity (you can withdraw at any time); the hedge fund usually has some sort of “lockup” provision. You can only get your money periodically.
- Absolute vs. Relative – the hedge fund aims for absolute return (it wants to produce positive returns regardless of what the market is doing); the mutual fund is usually managed relative to an index benchmark and is judged on its variance from that benchmark.
- Self-Investment – the hedge fund manager is expected to put some of his own capital at risk in the strategy. If he does not, it can be interpreted as a bad sign. The mutual fund does not face this same expectation.
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