Mutual Funds And Exchange-Traded Funds
There are three primary types of commingled pools of investments that are available to investors. They are open-end mutual funds, closed-end mutual funds, and exchange-traded funds (ETFs).
Open-end funds transact at the next available net asset value (NAV), which occurs after the market has closed for the day. Shares may be redeemed directly from the fund company with an open-end fund.
Closed-end funds transact throughout the trading day, but shares cannot be redeemed at the fund company and their price may differ substantially from their NAV—the shares must be bought or sold by other investors.
Exchange-traded funds also trade throughout the day, but their shares do trade at the NAV. ETFs usually have the lowest internal fees, which is a big component of investment returns.
Net Asset Value
The NAV is easily calculated as the total invested assets of the fund minus any liabilities (typically management fees payable) all divided by the total shares outstanding. The NAV for an open-end fund is set after the trading day is over, while the NAV for a closed-end fund and an exchange-traded fund is calculated continuously throughout the trading day. The NAV is used to determine the number of shares purchased or sold in a fund.
Active and Passive Management
Passive management is an attempt to mimic the performance of an index. Active management is an attempt to outperform a specific benchmark. Historical data suggests that actively managed funds have an average alpha near zero.
Hedge Funds
Both mutual funds and hedge funds offer professional management, instant diversification, and the ability to commingle funds with other investors.
However, there are some notable differences between mutual funds and hedge funds.
Hedge funds are only marketed to wealthy and sophisticated investors. Because of this, hedge funds escape certain regulatory oversight, which enables them to avoid allowing investors to redeem shares at any time they want, calculating the NAV daily, and disclosing investment policies and strategies. They are also permitted to use leverage and short selling, which are commonly not permitted for mutual funds. In addition, hedge funds use lock-up periods to prevent investor withdrawals at the wrong time for the fund.
Hedge Fund Expected Returns and Fee Structures
Hedge funds commonly deploy a 2% and 20% incentive fee structure, where they earn management fees for investment results relative to a given hurdle rate. Investors are partially protected with the use of high-water marks and clawback clauses.
Hedge Fund Strategies
There are many different types of hedge fund strategies. They all search for perceived mispricings in different corners of the markets and then try to exploit them for profit.
Long/short equity funds take both long and short positions in the equity markets, diversifying or hedging across sectors, regions, or market capitalizations, and have directional exposure to the overall market.
Dedicated short funds tend to take net short positions in equities, and their returns are negatively correlated with equities.
Distressed hedge funds invest across the capital structure of firms that are under financial or operational distress or are in the middle of bankruptcy. These hedge fund managers try to profit from an issuer’s ability to improve its operation or come out of a bankruptcy successfully.
Merger arbitrage funds bet on spreads related to proposed merger and acquisition transactions.
Convertible arbitrage funds attempt to profit from the purchase of convertible securities and the shorting of corresponding stock.
Fixed income arbitrage funds try to obtain profits by exploiting inefficiencies and price anomalies between related fixed income securities.
Emerging market funds invest in currencies, debt, equities, and other instruments in countries with emerging or developing markets.
Global macro managers make large bets on directional movements in interest rates, exchange rates, commodities, and stock indices and do better during extreme moves in the currency markets.
Managed futures funds attempt to predict future movements in commodity prices based on either technical analysis or fundamental analysis.
Hedge Fund Performance and Measurement Bias
Hedge fund benchmarks are problematic due to measurement bias and backfill bias. Over the last ten years, reported hedge fund performance suggests that they have only beaten the S&P 500 Index in two of those years.
