The investment landscape can be extremely dynamic and fast evolving. Those who take the time to understand the basic principles and the different asset classes are sure to gain a significant advantage over the long haul.
Understanding the investment risk ladder
The investment "risk ladder" identifies asset classes based on their relative riskiness, with cash being the most stable and alternative investments often being the most volatile.
A cash bank deposit is the simplest, most easily understandable investment asset—and the safest. Not only does it give investors precise knowledge of the interest they'll earn, but it also guarantees they'll get their capital back. On the opposite end of the ladder are the alternative investments, such as hedge funds and private equity funds. These are often designed to deliver beyond market returns, but they also carry greater risks. In this article we will focus on the difference between mutual funds, hedge funds and private equity.
Mutual funds
Mutual funds are managed portfolios built from pooled funds with the goal of achieving returns through diversification. These are normally offered to the public as regulated investment products and are available for daily trading.
The first mutual fund was created in 1924 and offered by the American-based MFS Investment Management. Since then, mutual funds have greatly evolved to provide investors with a wide range of choices in both passive and active managed investments.
Passive funds give investors the opportunity to invest in an index for targeted market exposure at a low cost. Active funds provide an investment product that offers the benefit of professional portfolio fund management.
Both open-end and closed-end mutual funds trade daily on the financial market exchanges. An open-end fund offers different share classes that have varying fees and sales loads. These funds price daily, at the end of trading, at their net asset value (NAV).
Closed-end funds offer a fixed number of shares in an initial public offering (IPO). They trade throughout the trading day like stocks. Mutual funds are available for all types of investors, but some of them can come with minimum investment requirements.
Generally, mutual funds are managed to trade securities based on a specific strategy. While strategy complexity can vary, most mutual funds do not heavily depend on alternative investing or derivatives. By limiting the use of these high-risk investments, it makes them better suited for the mass investing public.
Hedge funds
Hedge funds have the same basic pooled fund structure as mutual funds but they are only offered privately. Typically, they offer higher returns for the investors but they are also known for taking higher risk positions.
Hedge funds may use options, leverage, short-selling, and other alternative strategies and are usually managed much more aggressively than their mutual fund counterparts. Many seek to take globally cyclical positions or to achieve returns in markets that are falling.
While built around the same concepts for investing as mutual funds, hedge funds are structured and regulated much differently. The Italian regulator recognised and formalised fudge funds only in 1999 (Decreto 24 maggio n. 228, article 16). Since hedge funds offer their investments privately, this requires them to include only accredited investors and allows them to build their fund structure.
Accredited investors, who normally have an advanced knowledge of the financial market they are investing in, are willing to bypass the standard protections offered to mutual fund investors for the opportunity to potentially earn higher returns. As private funds, hedge funds also differ in that they usually deploy a tiered partnership structure which includes a general partner and limited partners.
The private nature of hedge funds allows them a great deal of flexibility in their investing provisions and investor terms. As such, hedge funds often charge much higher fees than mutual funds. They can also offer less liquidity with varying lock-up periods and redemption allowances.
Some funds may even close redemptions during volatile market periods to protect investors from a potential selloff in the fund’s portfolio. Overall, it is vital that hedge fund investors fully understand a fund’s strategy risks and governing terms. These terms are not made public like a mutual fund prospectus. Instead, hedge funds rely on private placement memorandums, a limited partnership or operating agreement and subscription documents to govern their operations.
Private equity funds
Private equity funds invest directly in companies, primarily by purchasing private companies, although they sometimes seek to acquire controlling interest in publicly traded companies through stock purchases. They frequently use leveraged buyouts to acquire financially distressed companies.
Unlike hedge funds focused on short-term profits, private equity funds are focused on the long-term potential of the portfolio of companies they hold an interest in or acquire.
Once they acquire or control interest in a company, private equity funds look to improve the company through management changes, streamlining operations, or expansion, with the eventual goal of selling the company for a profit, either privately or through an initial public offering in a stock market.
To achieve their aims, private equity funds usually have, in addition to the fund manager, a group of corporate experts who can be assigned to manage the acquired companies. The very nature of their investments requires their more long-term focus, looking for profits on investments to mature in a few years rather than having the short-term quick profit focus of hedge funds.
Final considerations
A key difference between hedge funds and mutual funds is their redemption terms. Mutual fund investors can redeem their units on any given business day and receive the NAV (net asset value) of that day. Hedge funds, on the other hand, tend to be much less liquid.
Ten years ago, hedge funds and private equity operated in two distinct realms - but no more. Hedge fund managers are increasingly offering vehicles outside their core funds with co-investment and longer duration private equity opportunities. At the same time, private equity managers continue to converge with credit and real estate opportunities as well as launching large vintage funds.
Many veteran investors diversify their portfolios using a variety of asset classes, with the mix reflecting their tolerance for risk.
Source: Investopedia - https://www.investopedia.com/