Mutual Funds and Hedge Funds

Mutual Funds and Hedge Funds in America, Europe and Asia

Mutual funds and hedge funds are part of a class of securities known as collective investment schemes. The basic premise of these schemes is that they allow investors the ability to invest in many different securities by purchasing just one. Each fund is essentially a financial intermediary. Groups of investors pool their money. The pool is managed by a professional, who takes the money and invests it in a range of securities. Each investor owns a unit of the fund, rather than the securities within the fund. The benefit is that the funds allow greater diversification than would be possible to the individual investor who would otherwise have to invest in each security on his or her own.

The Chinese market is burgeoning, but fraught with many challenges for would-be mutual and hedge fund managers. Savings rates are high and investors are risk averse, which is great for the mutual fund market. But the pool of available instruments is shallow, making it difficult to achieve superior returns. This shallow pool is only one of many problems inherent in setting up a hedge fund in mainland China, the other keys being lack of investor sophistication, weaknesses in the banking system and the dearth of fund management talent in Asia.

Mutual Funds

The term 'mutual fund' is the American name for a collective investment scheme. In most financial press, the term is globally understood. In Europe, other names are used to connote the same type of product. UCITS, short for Undertakings for Collective Investments in Transferable Securities, is the acronym for a legal status for collective investments that allows them to be marketed across Europe. In some countries, the term SICAV is also used. In some countries, the term 'managed fund' is preferred. In the UK, two terms are used interchangeably - OEIC and ICVC. OEICs have become popular in the UK, replacing unit trusts, which was the former preferred structure of collective investment in that country. There are sometimes slight differences in the manifestation of these products, so that whereas these terms, and the term 'mutual fund' have specific connotations in their countries, in most places 'mutual fund' is a generic term denoting any type of collective investment scheme.

The first mutual fund was founded in 1924 in the U.S. It was not until 1940 that legislation was enacted that gave mutual funds the form in which they are common today. Funds have proved exceptionally popular in recent years, growing from $48 billion in assets at the end of the 1960s to $12.356 trillion in assets today.

Mutual funds take many forms. One main division is between open-ended funds and closed-ended funds. An open-ended fund is one in which the fund remains open indefinitely to new capital. In this way, any investor can join the fund at any time. When new money is invested, new units are created to match the amount of the investment. The units remain a direct reflection of the underlying assets.

Closed-ended funds come with a fixed number of shares. These shares are typically issued as an IPO (initial public offering) and then traded through an exchange. There is an underlying value in the securities that the fund holds, but the price of the fund is not specifically related to that value, but rather due to supply and demand.

Mutual funds are a huge industry worldwide. Most funds have a focus. The focus can be either geographical (a Latin-America fund), based on industry (a technology fund) or even business characteristics (a small-cap fund or a growth fund). There are also funds that invest in securities other than stocks, such as money-market funds, bond funds and even funds of funds that invest in other mutual funds.

The main advantage of mutual funds is that they spread risk through diversification. By purchasing many different securities, the risk of any individual security losing money is offset by the likelihood that other securities will make money. Another advantage is reduced transaction fees. Each trade on an exchange costs money, so for an individual investor to acquire the securities in a given fund on their own would be prohibitively expensive. The cost of a mutual fund, in the form of a load (commission paid to the broker) and a management fee (paid to the fund manager) is much lower.

Hedge Funds hedge fund is another form of pooled investment. In the United States, hedge funds are subject to looser regulation by the Securities Exchange Commission and thus are not considered true mutual funds.

The creation of hedge funds is said to date to 1949. In essence, hedge funds are allowed to operate with looser regulation by limiting investment to qualified or "accredited" investors. So hedge funds are different from mutual funds in that they are not open to any investor. An accredited investor is typically one who can either demonstrate sufficient wealth to withstand the greater risk inherent in most hedge funds, or who can demonstrate a certain amount of knowledge and experience with securities markets. Aside from this, there is no set definition for the term 'hedge fund', although the term does carry essentially the same connotation worldwide.

There are a couple of other ways in which hedge funds differ from mutual funds. One is that whereas mutual funds are relatively liquid, hedge funds are often not. A mutual fund unitholder can sell a fund at any time, but hedge funds are often locked-in for a set period, and sales within this period are subject to a fee known as a surrender charge. Another key difference is that mutual fund prices are posted publicly each business day. Some hedge funds never post the value of their units, and those that do often do so only infrequently.

Hedge funds are distinguished by two things - their investment philosophies and their investment strategies. Many hedge funds seek to play a minority role in any given investor's portfolio (hedge funds will often form 5% of a total portfolio), with the objective of offsetting ('hedging') the risk that the investor has by way of their more standard market investments.

In terms of investment strategy, a typical mutual fund will invest in a specific instrument, usually either common stock or debt. Hedge funds frequently make use of far more sophisticated investment strategies, utilizing instruments such as short-selling, derivatives and futures. These sophisticated strategies form the core of the competitive advantage for many hedge funds. That said, most hedge funds are basic long-short funds, the bulk of their holdings being long or short equity positions.

Hedge funds have only one unifying feature, and that is that the compensation for the fund managers is incentive-based. That is, hedge fund managers take a portion of the profits for themselves. This typically ranges between 20-30% of profits, but can go as high as 50% for the industry leading funds. Further to this is the concept of a "high-water mark." This is when a fund manager does not receive performance fees unless the fund surpasses the previous highest level. This idea has come into place as a means to provide incentive to the fund manager to seek long-term gains, as opposed to engaging in high-volatility trading.

In light of that, there are dozens of types of hedge funds. Some of the basic ways in which hedge funds are broken down are by style, by market (i.e. equity, fixed income, commodities), by instrument (i.e. long/short, futures, options), exposure (directional or market neutral), by industry sector and by method. With respect to the latter, there are two forms - discretionary (managed by a fund manager) and systematic (managed by software). Some hedge funds are event-driven. These include funds specializing in distressed companies, merger arbitrage, and special situations. There are also hedge funds that specialize in owning other hedge funds.

Hedge funds are usually considered riskier investments than a typical mutual fund. There are several reasons for this. First, they are not subject to the same strict regulations as laid down by the SEC or other national securities regulator. This leads to looser controls and sometimes a lack of transparency. Many hedge funds are highly leveraged. This puts the investors' capital at greater risk. Short-selling is a common feature in hedge funds, and again increases the investors' exposure.

Hedge funds have, up until recent years, been primarily an American investment vehicle. The market in London was just $60 billion in 2002. That figure has exploded, however, to $400 billion today. New York and adjacent areas form the global center for hedge funds in terms of fund management (most of the world's funds themselves are technically based in the Caymans). London is the center for the industry in Europe, with about three-quarters of the business. The Asia region is headquartered in Hong Kong, with Singapore making inroads into the hedge fund business.

The Mutual Fund Industry - Success Factors

The two main success factors in the mutual fund industry are performance and marketing. Performance is a multifaceted factor. The first aspect of successful mutual fund performance is to define a benchmark. Most funds have specific benchmarks that they use both internally and externally. Externally, the benchmarks are often used in promotional material, relating the performance of the fund to the performance of the Dow Jones Industrial Index or some other broad-based market indicator. Funds operating in specific sectors will benchmark against a sector index. The idea behind this is that the fund should demonstrate a track record of success - otherwise the investor should simply purchase the Index, many of which are available as exchange-traded funds. Internally, fund benchmarks are more complex. For example, the risk level of the fund relative to the market is factored into the equation.

The next component of mutual fund performance is the ability to analyze securities. Most major fund companies employ experts who can make specific recommendations within a given sector. The success of a fund company depends in part on the strength of these analyses, as they form the basis for the investment decisions made by the fund's manager.

The investment decisions themselves are another key factor in fund performance. Part of successful fund management is knowing what to invest in, and part is knowing when to make the investment and when to divest. Fund managers with consistent track records of outperforming their respective benchmarks become stars within the industry, and savvy investors or investment advisors seek out products associated with those fund managers.

In that regard, retention of top fund management talent is another key success factor in the mutual fund industry. Investors understand that the past performance of a mutual fund is not a guarantee of future success, but they like to improve the odds by investing in funds whose managers have a consistent track record of success. It is imperative that firm's retain successful fund managers to ensure the continued marketability of that particular fund.

Another success factor in the mutual fund industry is marketing. Mutual funds are considered "public" investments in that they are available for sale to all investors. There are thousands of funds available, so competition is intense. There are multiple channels for distribution - either direct to the investor or through an investment advisor. Therefore mutual fund companies spend hundreds of millions of dollars marketing through these two channels.

Fund companies attempt to differentiate their offerings, on the basis investment philosophy, management fee structure (price) or a particularly strong track record of past performance. Some fund companies differentiate on the basis of their distribution channels. Some focus on direct sales to consumers, others deal almost exclusively through investment advisors, to whom they market extensively with dedicated sales representatives. Several fund companies are distributed exclusively through a single financial institution.

The leading mutual fund firm is Fidelity Investments with $1.57 trillion in assets under management in the U.S. And a further $280 billion under management outside the U.S. They offer a comprehensive package including advisory services, discount brokerage, estate management and life insurance.

Fidelity's success has been on the basis of its strong fund performance and its innovative marketing. Its Contrafund is the largest mutual fund in the U.S., and its Magellan fund is the second-largest (and former #1). Fidelity has actively targeted the baby boomer market, placing a strong focus on financial security and lifestyle imagery.

The second-largest fund manager in the U.S. is the Vanguard Group. They are a cost-oriented firm and a pioneer of index funds. Whereas many other funds were benchmarked against an index, Vanguard introduced the idea of buying a fund that mirrored the index itself. These funds are popular amongst conservative investors, who prefer the perceived stability of "doing what the market does" and passive investors, who do not believe it is possible to consistently beat the market on a risk-weighed basis. Founder John Bogle launched the idea when he realized that three-quarters of fund managers did not beat the S&P 500 Index.

Vanguard has a unique ownership structure that it lauds as a competitive advantage, in that it is owned by the funds themselves. This is because Vanguard is not expected to make a profit for itself, or that if it does this will be returned to the unitholders. Vanguard's fund are "no-load" and the company maintains a low cost structure, which means that they are competing on the basis of price.

The number three company is American Funds. American does not advertise to the public, but rests its success on the recommendation of investment advisors and their track record of performance.

The Hedge Fund Industry - Success Factors

The hedge fund industry is characterized by several differences from the mutual fund industry. The first is the target market itself. Because hedge funds are targeted exclusively to accredited investors, they do not engage in public marketing the way conventional funds do. This alters one of the key success factors. Marketing is not as important to hedge funds. Indeed, many hedge funds do not even have websites. Since most hedge funds are closed, marketing is only important during the initial round of capital-building. To that end, the key success factor is that of the fund marketers to build relationships with investment advisors and large individual investors. Much of the recent growth in hedge funds is attributable to the institutional market as pension funds and insurance companies seek to diversify into a greater variety of asset classes and make gains beyond that which the standard equity market offers.

The performance aspect of hedge fund performance is more complex, given the wide range of objectives within the hedge fund universe, but the ultimate goal remains the same - a successful hedge fund must demonstrate strong performance. In the hedge fund industry, most firms will launch a series of funds and the ability to raise capital for one fund will depend on the success of any previous funds from that firm or manager. No matter what tools, sectors or strategies are involved, the manager must be able to consistently meet or exceed the fund's benchmarks in order to ensure continued success.

Performance is so important to the hedge fund industry that most funds are highly secretive, wary of divulging their proprietary investment strategies. In this way, they protect the one competitive advantage that they have - if secrets of their success were known, they would cease to have any such advantage.

Performance is especially critical in light of the fiscal structure of hedge funds, whereby the fund makes its money by taking a percentage of gains. Leading hedge fund manager, SAC, takes 50% of the gains of their funds. In order to continue to attract investors given such a figure, SAC must demonstrate consistent superior performance.

Another leading hedge fund manager is Renaissance Technologies. As with SAC, the appeal of the company is its performance, which is estimated at 35% per year. It is worth noting that the beta of the fund (that is to say its risk relative to the market) is not known. This shows that while the term performance to hedge funds sometimes means, at least externally, raw performance, rather than risk-weighted performance.

To achieve its high level of performance, Renaissance employs some 150 mathematicians and statisticians to study and chart market movements in order to anticipate future shifts in prices. This is an example of how expertise is the specific driver of hedge fund performance. Each fund has very unique characteristics, and the performance of the fund is largely dependent on the fund manager and the research team to develop expertise in the specific area of specialization of the fund. Hedge funds often seek to develop sustainable competitive advantage by specializing in complex investment strategies. In addition to the team of mathematicians, Renaissance employs computer programs to conduct the bulk of its trading, which again lends them a sustainable competitive advantage in terms of delivering consistently superior performance.

ESL, a fund operated in the Berkshire Hathaway mold, is another major player in the hedge fund industry. The key success factor is performance, born of long-term plays driven by in-depth fundamental analysis. ESL holds relatively few positions, and does not engage in sophisticated strategies to the degree that many other hedge funds do.

The European hedge fund industry is dominated by London firms, such as the Man Group, GLG and BlueCrest. London represents some three-quarters of all European hedge fund business, and English funds represent all ten of the top ten European hedge funds. France and Switzerland are secondary players. The industry is small relative to the American industry, but is growing rapidly, at a time when new fund launches in the U.S. are slowing down. The industry worldwide, however, is growing in terms of assets under management.

The hedge fund industry is Asia is nascent, and largely based out of Hong Kong. There are several Asian-focused hedge funds in Europe and North America. Three leading Hong Kong-based hedge fund managers are Ward Ferry Management, Value Partners, and ADM Capital. Singapore is a competitor to Hong Kong, thanks to an especially lax regulatory environment, but Hong Kong has most of the managerial talent due in large part to the fact that most American and European hedge funds specializing in Asia are based there.

Mutual Funds and Hedge Funds in the Chinese Market

The Asian market for hedge funds is booming. Growth has been estimated at 30% per annum over the past five years and the market is estimated to have some $176 billion in assets under management. With over 1200 funds available, the market is expected to grow to nearly $1 trillion by 2013 fuelled by both demand and the increasing availability of high-level support services. That hedge funds have demonstrated to be, on aggregate, a very effective tool for risk management, has also helped fuel their popularity in the region.

Moreover, the market is becoming increasingly sophisticated, with managers engaging in increasingly sophisticated investment strategies. Relative to western markets, Asian markets have stringent anti-money-laundering and know-your-client regulations. This is in addition to a more conservative mindset, due in part to the crisis ten years ago, which has left Asian managers and consumers alike wary of finding themselves overleveraged. The traditionally high rate of savings in China makes that market in particular a compelling draw for fund managers.

There remains some volatility in the Asian market in terms of returns. There are many entrepreneurs who have entered the hedge fund business in recent years, only to leave the industry scant months or years later. While on the one hand this gives an opportunity for experience managers to tap into this market on the back of their track record, it may also create trepidation among consumers already burned by investments in fly-by-night fund managers. Risk aversion is higher amongst Asian consumers than Western ones.