Thinking about starting up a hedge fund? While the draw of wealthy investors handing over megabucks, returns that don't depend on the stock market and the allure of beefy performance incentive fees are certainly compelling reasons to dive into the market, operationally, hedge funds and mutual funds are worlds apart.
While mutual funds must be registered with the Securities and Exchange Commission as investment companies, traditional hedge funds are not SEC-registered and are usually structured as limited partnerships, limited liability companies or business trusts. Each carries its own unique characteristics and tax structure.
Depending on the specific structure of the hedge fund, the fund might be limited to 99 "accredited" investors, and in some cases up to a maximum of 499. In contrast, the sky's the limit on the number of investors mutual funds can have on board. And in retail mutual funds, investors do not have to attest to the value of their total assets or annual income, which is a condition for being considered an "accredited" investor in the hedge fund world.
Since hedge funds are not as highly regulated, a lack of transparency is often an issue in hedge funds, while mutual funds must provide portfolio holdings twice-per-year and send quarterly account statements to investors.
Because they offer daily liquidity, mutual funds must provide the daily pricing of all securities in their portfolios by determining a fund's daily net asset value (NAV) per share. Unlike mutual funds which promise to redeem shares on any given business day, hedge funds usually have lock-up periods during which investors are required to stay put in the fund.
Hedge funds aren't required to price daily, so most don't. Instead, hedge fund administrators determine their equivalent NAVs on a monthly basis and, in a few cases, a weekly basis.
However, just like mutual funds, hedge fund administrators do reconcile all trades each and every day, said Jennifer Stier, managing director of Hemisphere in Boston, which BISYS of New York acquired earlier this year.
Another difference lies in restating net asset values. Mutual funds cannot restate net asset values. But hedge funds can, and might even need to go as far back as two months to cancel and correct trades because hedge funds have far fewer money flows both in and out, Stier said
Another big difference is fees. Mutual funds charge an annual investment advisory fee that is paid from the fund in installments throughout the year. That fee, also called the management fee, is necessary so that the fund's investment advisor can pay for office space, portfolio managers' and analysts' salaries, resources and other expenses necessary to manage the fund on a day-to-day basis. The fee is calculated on the current net assets of the fund. Management fees vary greatly and can be as low as 15 basis points or as high as 175 basis points or more, according to Jeff Keil, VP at Lipper of New York.
Hedge fund managers similarly charge a flat management fee which ranges from 100 to 200 basis points, also calculated based upon net assets of the fund. But hedge fund managers layer atop that management fee a "performance incentive" fee which usually runs between 10% and 20% per year based upon the profits a fund manager has achieved in the fund.
Redemptions differ between mutual funds and hedge funds. Depending on when a redemption request is received, most open-end mutual funds execute a redemption on that day or the next business day, although they legally have up to seven days to redeem shares for an investor.
Hedge funds, on the other hand, usually require a much longer lead time to process redemptions mainly because hedge funds often invest in illiquid securities. Assuming the required lock-up period has already passed, hedge fund managers usually require between 10 and 90 days' advance notice of a redemption request, Stier said. And managers often will then only allow investors to exit at the end of the next quarter.
Tax and Accounting
Accounting and tax reporting are also very different for hedge funds than for mutual funds. If the hedge fund is set up as a partnership, a more detailed partnership accounting is required, which allocates to each partner based upon his or her interest in the fund. Hedge funds must generate complex K-1 reports. Mutual funds generate 1099 earnings reports, which are based upon shares held and simply break out long-term versus ordinary income for tax purposes.
While partnership accounting in hedge funds can be complex, it's really basic accounting, said Patrick Adams, president of Choice Investment Management of Englewood, Col., and manager to three open-end mutual funds and the Adams Select Fund, a hedge fund. In a hedge fund, each partner is taxed upon his individual investment and profits. But in a communal mutual fund, an investor assumes the current tax gain or loss of that fund caused by investors who have come and gone before.
"In this market, with lots of mutual funds seeing realized losses, that can be a benefit to going into a mutual fund," he said.