Hedge Fund Investing. Mirabile Kevin R.

for the day-to-day processing of securities purchases and sales, income collection or payment, fund expenses, borrowing money, reinvesting cash, and reconciling positions with traders, administrators, and brokers.

      A general counsel, who is the primary legal officer of the firm and is responsible for all internal and external legal matters, including the fund’s offering documents and the firm’s relationships with outside counsel.

      A head of investor relations, who is responsible for sales and service of the firm’s individual and institutional investors, as well as most of the firm’s communications and reporting to investors.

      A head of human resources or talent management, who is the person responsible for policies and procedures related to finding, onboarding, and retaining talent at a firm.

      A treasurer, who is the person responsible for managing the fund’s cash flow, funding lines, credit facilities, and liquidity.

Figure 1.2 shows the typical roles and reporting lines for a well-established hedge fund that is managing money on behalf of both high-net-worth individuals and institutional investors.

FIGURE 1.2 Hedge Fund Organizational Model

      Although all these roles are certainly not essential on day one, most will be added as the funds grow in size and complexity or as they attract more institutional investors.

HEDGE FUNDS VERSUS MUTUAL FUNDS

      A mutual fund is a highly regulated investment vehicle managed by a professional investment manager. It aggregates smaller investors into larger pools that create economies of scale and efficiency related to research, commissions, and diversification. Mutual funds have been available to investors in a wide range of asset classes since the mid-1970s and became increasingly popular in the 1980s and 1990s as a result of retail attention, product deregulation, and solid returns. Mutual funds generally cannot use leverage or short selling and generally cannot use most derivatives. Collective investment products originated in the Netherlands in the 18th century, became popular in England and France, and first appeared in the United States in the 1890s. The creation of the Massachusetts Investors’ Trust in Boston heralded the arrival of the modern mutual fund in 1924. The fund went public in 1928, eventually spawning the mutual fund firm known today as MFS Investment Management. State Street Investors started its mutual fund product line in 1924 under the stewardship of Richard Paine, Richard Saltonstall, and Paul Cabot. In 1928, Scudder, Stevens, and Clark launched the first no-load fund.

      The creation of the Securities and Exchange Commission and the passage of the Securities Act of 1933 and 1934 provided safeguards to protect investors in mutual funds. Mutual funds were required to register with the SEC and provide disclosure in the form of a prospectus. The Investment Company Act of 1940 put in place additional regulations that required more disclosures and sought to minimize conflicts of interest. At the beginning of the 1950s, the number of open-end funds topped 100. In 1954, the financial markets overcame their 1929 peak, and the mutual fund industry began to grow in earnest, adding some 50 new funds over the course of the decade. The 1960s saw more than 100 new funds established and billions of dollars in new investment inflows. The bear market of the late 1960s resulted in a temporary outflow and a minor reversal of the trend in growth. Later, in the 1970s, Wells Fargo Bank established the first passively managed index fund product, a concept used by John Bogle to found the Vanguard Group. Today, mutual funds manage more than $15 trillion on behalf of a wide range of investors.

      Hedge funds only emerged as an investment product in the late 1960s. Alfred Winslow Jones is considered to have been the first hedge fund manager, in that he used leverage and short selling to modify portfolio returns and was paid an incentive fee. Hedge funds, however, provide investors with investment opportunities that are very different from those available from traditional investments such as mutual funds. Hedge funds are also regulated and structured differently from mutual funds and thus have certain unique properties, although both operate using expert managers on behalf of passive investors. Hedge funds are designed to offer investors an absolute return, less volatility, and lower correlation to traditional investment benchmarks such as the S&P 500 and the various bond indices.

      Hedge funds offered as private onshore or offshore funds do share some common features with the more traditional mutual fund; however, they also have some very significant differences. There are seven major differences between a private hedge fund and a traditional stock or bond mutual fund that are worth noting:

      1. Performance measurement

      Mutual fund success or failure is based on relative performance versus some benchmark or index. Performance is compared to a particular index that is considered suitable to capture passive returns from a particular asset class. Equity mutual funds are commonly benchmarked against an index such as the S&P 500. Hedge funds, on the other hand, are designed to generate positive returns in all market conditions and as such are referred to as absolute return investments that can generate mostly alpha for their investors.

      2. Regulation

      The mutual fund industry is highly regulated in the United States, whereas regulation of the hedge fund industry is only just beginning to emerge in many markets, including the United States. A mutual fund’s design, terms, liquidity, performance calculations, and other features are prescribed by regulation. In addition, they are generally restricted from many types of transactions, including the amount of leverage, short selling, and derivatives. Hedge funds, by contrast, are only lightly regulated and therefore much less restricted. They are allowed to short sell securities, use leverage, add derivatives to their portfolios, and use many techniques designed to enhance performance or reduce volatility.

      3. Compensation model

      Mutual funds are generally rewarded and compensated by a fixed management fee based on a percentage of assets under management. The fee generally varies by asset class, with money markets and fixed income earning the lowest fees and active equity or credit strategies earning the highest. Hedge funds are generally compensated with both a fixed management fee and a variable performance fee based on the funds’ results.

      4. Protection against declining markets

      Most mutual funds are designed to track or outperform an index and as such generally need to stay close to 100 percent invested in a specific asset class. In some limited cases, they can use put options or short index futures for hedging. Mutual funds are not normally designed to protect investors against declining markets. Hedge funds, however, are almost always designed to offer some protection against declining markets.

      5. Correlation to traditional asset classes

      The performance of most mutual funds is dependent on the direction of the equity or bond markets. The performance of many hedge fund strategies has a low, perhaps even negative, correlation to the stock or bond market.

      6. Leverage, short selling, and derivatives

      Most mutual funds are restricted by regulation from the use of leverage, short selling, or derivatives. When permitted to do so, they can do so only in varying degrees and within strict limits. Even those that can use leverage, short selling, and derivatives often do not, as the firm may lack the expertise and training to do so effectively. Almost every hedge fund can use some combination of leverage, short selling, or derivatives to modify returns and lower volatility.

      7. Liquidity

      Most mutual funds offer daily liquidity. In cases where liquidity is restricted, investors most often can exit the fund by paying a penalty. Hedge fund investors usually can redeem only periodically, based on the strategy of the fund. Redemption is usually monthly or quarterly. In some cases it may extend to one or two years.

      Despite the differences noted above, some hedge fund strategies, such as global macro and long and short equity, previously offered only in private fund formats, are now offered as mutual funds. Many fund managers now offer a combination of private and public funds using LPs, LLCs, and mutual funds or UCITS products. Larger firms also offer managed accounts and customized portfolios to significant institutional