Hedge Fund vs Mutual Fund

Hedge Fund vs Mutual Fund

We’ve recently been asked what the difference is between a Mutual Fund and a Hedge Fund and why Hedge Funds, like The Portfolio Platform, have the ability to make so much more money. 

For those unfamiliar with professional investing, this is an interesting question and one that reveals all is not what it seems, so we will attempt to answer it for you.

What is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of capital, from essentially selling shares in itself on the open market. It then uses that money to invest in securities like stocks, bonds and money market instruments. They are run by a fund manager whose job it is to select a range of assets and increase the value of the holdings.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market capitalisation of the fund—derived by the aggregating performance of the underlying investments.

This means when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio's value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. The Fund Manager is the dictator and answers to no one. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.

That's why the share price of a Mutual Fund is referred to as the net asset value (NAV). A fund's NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. 

To clarify, let’s take an example where you have £5,000 to invest. You want to buy a selection of stocks to build a well-diversified portfolio, but the fact is, you will struggle to do so.

You would be very limited on the number of stocks you would be able to buy due to a lack of capital. If you wanted to buy 1 Amazon share and 1 Alphabet (Google) share you would need to stump up $6,554 just for those 2 shares. At this point, you’re almost out of capital and your portfolio is far from diversified.

However, with that same amount of capital, if a mutual fund share is £50, you could buy 100 shares and give yourself exposure to the value of the fund that will likely own hundreds of different stocks.

It works well, particularly for the small investor but they are not without their own disadvantages.

1. Hidden Fees – The cost of a mutual fund is actually quite high. It might be less than an IFA, but it is still high in terms of modern investing options. They call it ‘expense ratio’ because it sounds less like a fee, but there is no getting round the fact that you are probably paying about 1% for a very limited return.
2. You have no control over the investment. You could choose a fund that is focused on a certain sector, but ultimately, the fund manager will only disclose the position either monthly or quarterly.
3. Lack of Liquidity and no available price until the end of the day.
4. Sales charges

Overall, a mutual fund isn’t a bad option if you want low risk, and diversified exposure to the market with limited capital.

So, what is a Hedge Fund?

Hedge funds are actively managed investment pools whose managers use a wide range of strategies, often including buying with borrowed money and trading esoteric assets, in an effort to beat average investment returns for their clients. They are considered risky alternative investment choices.

Hedge funds require a high minimum investment or net worth, excluding all but wealthy clients

The term "hedge fund" helps tell the original story, but has little to do with the current narrative. The manager of any traditional investment fund may devote a portion of the available assets to a hedged bet. That's a bet in the opposite direction of the fund's focus, made in order to offset any losses in its core holdings.

There is also a common belief that because hedge fund managers are so rich, hedge funds must make investors a lot of money in the same way the traders do on The Portfolio Platform. However, here is the truth:

Warren Buffett always said the best thing to invest in is a long-term index tracker, and looking at this graph, he was right on the money. That is why at TPP we have built several leveraged trackers for autotraders to link to. 

If you’re in for the long term, link to the S&P tracker which follows the S&P at 3x the rate of a standard tracker making you 3x the returns. 

History of Hedge Funds

An Australian investor and financial writer Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company, A.W. Jones & Co.

He raised $100,000 (including $40,000 out of his own pocket) and set up a fund that aimed to minimize the risk in long-term stock investing by short-selling other stocks. This innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance the returns of his fund, in much the same way we do on TPP.

As hedge fund trends evolved, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging, and engaged in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74

Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds failed in spectacular fashion.

In modern times, hedge fund managers have gone to even more extremes. In fact, their funds now have little to do with hedging.

These days, most hedge funds are increasing leverage hoping to get a large performance pay-out. This is why we don’t offer our traders at TPP a performance fee. All it tends to do is encourage greed and misuse of funds. We have built a model that works for the investor, which should surely be the priority?

Leverage and looking for an increased return are not bad things, people want more these days, but the name should be changed. Derivatives were originally a hedging tool. Futures and options could be used to cover downside losses in a market that goes against you, now, they are used almost entirely for leveraged returns on riskier investments.

There is a place for this in the financial world and many people are looking for more from their money, but let’s call a spade a spade: a ‘Hedge Fund’ does not provide a hedge, it does whatever it wants to make money.

How do you tell a hedge fund from a mutual fund? Here are a few big differences between the two.

Hedge Funds Exclude Small Investors

Hedge funds can accept money only from "qualified" investors and institutions due to their ‘higher risk, higher return’ nature. Generally speaking, as a retail investor, you cannot invest in a hedge fund unless your net worth exceeds several million pounds. Their alternative investment strategies and leveraged positions place them out of the reach of the public.

The Portfolio Platform offers similar trading strategies that can be invested in with as little as £20,000. You can now build your own online portfolio, with less capital and lower fees.

Hedge Fund Managers Have a Wide Latitude

A hedge fund's investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies.

Mutual funds, by contrast, stick to stocks or bonds and invest for the long term.

Hedge Funds Often Use Leverage

Similar to the traders on The Portfolio Platform, hedge funds often use leverage to amplify their returns and allow them to take occasional aggressive short positions.

Mutual funds cannot use leverage, and cannot short-sell so will only make money in a rising market.

Hedge Funds Have a "2 and 20" Fee Structure

Mutual funds fees have fallen substantially in the last few years averaging around 1%

Hedge funds, by contrast, use a fee structure that is called, in shorthand, "2 and 20." That's 2% of the assets under management plus a 20% cut of any profits generated. 

This has led to enormously overpaid hedge fund managers who earn millions, or even billions, regardless of whether they perform.

Do these figures annoy you? They certainly do us. Renaissance, number two on the list, has suffered huge losses over the last year and seen $11bn pulled out of its fund. This is not uncommon as managers become famous and look for bigger wins. It also doesn’t stop James Simons from cashing in an enormous pay-out every year.

What we have done at The Portfolio Platform is build a retail friendly model that gives investors access to traders who use leverage properly, and successfully. Anyone can now build a portfolio that contains both vanilla equity trackers, and riskier active trading strategies.

The costs are transparent, as is the trading. It’s 100% liquid and the investor has complete control. 

Traders are paid via a subscription model, so if they perform well over time, they will get more subscriptions. This avoids unnecessary risk and looks to build a long-term ROI that competes with anything anywhere else in the market.

If this sounds like something you are lacking, please do contact us and we’d be happy to chat. We really do believe this is the future of investing.