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The Differences Between Mutual Funds and Hedge Funds

Mutual funds and hedge funds differ in many ways, particularly the fees charged; leveraging, pricing, and liquidity practices employed; the degree of regulatory oversight to which each is subject; and the characteristics of the typical investors who use each investment vehicle.

U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure they operate in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight.

Regulatory Requirements

Mutual Funds

Mutual funds are investment companies that must register with the U.S. Securities and Exchange Commission (SEC) and, as such, are subject to rigorous regulatory oversight. Virtually every aspect of a mutual fund’s structure and operation is subject to strict regulation under four federal laws: the Securities Act of 1933, the  Securities Exchange Act of 1934, the Investment Company Act of 1940 and the  Investment Advisers Act. The SEC is charged with overseeing the mutual fund industry’s compliance with these regulations. The  Internal Revenue Code sets additional requirements regarding a fund’s portfolio diversification and its distribution of earnings, and the National Association of Securities Dealers, Inc. (NASD) oversees most mutual fund advertisements and other sales materials. In addition, mutual funds must have directors who are responsible for extensive oversight of the fund’s policies and procedures. For virtually all funds, at least a majority of their directors must be independent from the fund’s management.

The  Investment Company Act is the cornerstone of mutual fund regulation. It regulates the structure and operation of mutual funds and requires funds to safeguard their portfolio securities, forward price their securities, and keep detailed books and records. In addition, the 1933 Act requires all prospective fund investors to receive a prospectus containing specific information about the fund’s management, holdings, fees and expenses, and performance.

Hedge Funds

Hedge funds—unlike mutual funds—are not required to register with the SEC. They issue securities in “private offerings” not registered with the SEC under the Securities Act of 1933. Furthermore, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934.

Like mutual funds and other securities market participants, hedge funds are subject to prohibitions against fraud, and their managers have the same fiduciary duties as other investment advisers.

Fees

Mutual Funds

Federal law imposes a fiduciary duty on a mutual fund’s investment adviser regarding the compensation it receives from the fund. In addition, mutual fund sales charges and other distribution fees are subject to specific regulatory limits under NASD rules. Mutual fund fees and expenses are disclosed in detail, as required by law, in a fee table at the front of every prospectus. They are presented in a standardized format, so that an investor can easily understand them and can compare expense ratios among different funds.

Hedge Funds

There are no limits on the fees a hedge fund adviser can charge its investors. Typically, the hedge fund manager charges an asset-based fee and a performance fee. Some have front-end sales charges, as well.

Leveraging Practices

Mutual Funds

The Investment Company Act severely restricts a mutual fund’s ability to leverage or borrow against the value of securities in its portfolio. The SEC requires that funds engaging in certain investment techniques, including the use of options, futures, forward contracts and short selling, “cover” their positions. The effect of these constraints has been to strictly limit leveraging by mutual fund portfolio managers.

Hedge Funds

Leveraging and other higher-risk investment strategies are a hallmark of hedge fund management. Hedge funds were originally designed to invest in equity securities and use leverage and short selling to “hedge” the portfolio’s exposure to movements of the equity markets. Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques. Many are very active traders of securities.

Pricing and Liquidity

Mutual Funds

Mutual funds are required to value their portfolios and price their securities daily based on market quotations that are readily available at market value and others at fair value, as determined in good faith by the board of directors. In addition to providing investors with timely information regarding the value of their investments, daily pricing is designed to ensure that both new investments and redemptions are made at accurate prices. Moreover, mutual funds are required by law to allow shareholders to redeem their shares at any time.

Hedge Funds

There are no specific rules governing hedge fund pricing. Hedge fund investors may be unable to determine the value of their investment at any given time

Investor Characteristics

Mutual Funds

The only qualification for investing in a mutual fund is having the minimum investment to open an account with a fund company, which is typically around $1,000, but can be lower. After the account has been opened, there is generally no minimum additional investment required, and many fund investors contribute relatively small amounts to their mutual funds on a regular basis as part of a long-term investment strategy.

Hedge Funds

A significantly higher minimum investment is required from hedge fund investors. Under the Investment Company Act of 1940, certain hedge funds only may accept investments from individuals who hold at least $5 million in investments. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals. Hedge funds can also accept other types of investors if they rely on other exemptions under the Investment Company Act or are operated outside the United States.

Visit the SEC website for more complete information on hedge funds.

April 2007