Hedge funds vs. mutual funds

Question 1

Mutual fund

Answer 1

• Transparency: Regulations require public disclosure of strategy and portfolio composition – fund prospectus
• Investors: Number is not limited, one specific aim is to attract more investors (e.g. rankings)

Question 2

Hedge funds

Answer 2

• Transparency: Limited Liability Partnerships with minimal disclosure of strategy and portfolio composition
• Investors: No more than 100 “sophisticated” and wealthy investors

Question 3

Hedge funds

stragety

Answer 3

Investment Strategies: Very flexible, funds can act opportunistically and make a wide range of investments
•Often use shorting, leverage, options

Question 4

strategy

Mutual funds

Answer 4

• Investment Strategies: Predictable, stable strategies, stated in prospectus
• Limited use of shorting, leverage, options – stricter regulation

Question 5

Hedge funds

•Liquidity:

Answer 5

Have lock-up periods, require advance redemption notices

Question 6

Mutual funds

•Liquidity

Answer 6

Investments can be moved more easily (but not without costs) into and out of a fund

Question 7

Typical compensation structure

Answer 7

Management fee of 1-2% of assets and an incentive fee of 20% of profits

Question 8

Typical compensation structure

Answer 8

Fees are usually a fixed percentage of assets, typically 0.5% to 1.5%

Question 9

Hedge fund strategies

Answer 9

•Directional
–Bets that one sector or another will outperform other sectors
–These strategies are ‘timing’ based: move to the right sector at the right time

•Non-directional
–Exploit temporary misalignments in relative valuation across sectors
–Buy one type of security and sell another
–Strives to be market neutral

Question 10

Hedge fund strategies

Answer 10

•Convertible arbitrage
–Hedged investing in convertible securities, e.g. long convertible bonds, short stock

•Dedicated short bias
–Net (not pure) short position, typically in equities

•Emerging markets
–Try to exploit market inefficiencies in emerging markets. Typically long-only as short selling might be prohibited or infeasible in the market

•Equity market neutral
–Long/short hedges with control for exposures to industry, size, etc. to establish market neutral positions, often using leverage

•Event driven
–Specializes in corporate events, like M&A, restructuring, bankruptcy

•Fixed-income arbitrage
–Detects and exploits pricing anomalies

Question 11

Hedge fund strategies

Answer 11

•Global macro
–Involves long and short positions in capital or derivative markets across the world

•Long-short equity hedge
–Equity oriented positions on either side of the market, dependent on the outlook, not market neutral

•Managed futures
–Uses financial currency or commodity futures and is based on technical trading rules

•Statistical Arbitrage
–It relies on trading algorithms: uses quantitative systems that seek out many temporary and modest misalignments in prices and involves trading in hundreds of securities a day with short holding periods

–Pairs trading: pair up similar companies whose returns are highly correlated but one is priced more aggressively

Question 12

Potential omitted factors

Answer 12

–Liquidity: level vs. risk
–Survivorship bias/backfill bias
–Changing factor loadings
–Tail events

Question 13

Backfill bias:

Answer 13

–Hedge funds report returns only if they choose to, and they may do so only when their prior performance is good

Question 14

•Survivorship bias:

Answer 14

–Failed funds drop out of the database

–Hedge fund attrition rates are more than double those for mutual funds