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Funds less transparent, more expensive

Date: Saturday, June 2, 2007
Author: Jonathan Chevreau, Financial Post

The difference between hedge and mutual funds

The investing business has always been faddish. The trendiest investment vehicle in the 1990s was mutual funds. This decade, hedge funds are the big thing. But what exactly is the difference?

Let's start with the similarities. There are many, which is why some cynics say hedge funds are merely "mutual funds on steroids." Mutual funds have diversified portfolios of securities, lovingly chosen by professional managers. So do hedge funds.

Mutual funds charge high investment management fees, typically 2.5% in Canada. A recent academic study confirmed Canada's fund management expense ratios (MERs) are higher than 18 other countries.

Hedge funds charge even higher fees, since most also charge 20% performance fees on profits generated beyond a certain "watermark." In case they don't, hedge funds also charge a basic 2% annual fee just for trying (as do mutual funds).

Mutual funds are notorious for being "sold, not bought." Investors generally do not seek out mutual funds: salespeople push them on clients because they're compensated well for doing so. So are hedge funds, says Larry Swedroe, author of What Wall Street Doesn't Want You to Know.

By contrast, investors tend to seek out exchange traded funds and low-cost investments on their merits: they don't need to be sold them.

But there are also big differences between the two. Hedge funds are less regulated than mutual funds. The little guy can't afford to lose his nest egg, so regulators won't let most mutual funds short stocks or use leverage (borrowed money).

Hedge funds have fewer constraints. Their portfolios can be concentrated in fewer names, adding both to the risk and potential return. Rich people can afford the risk if the bets turn sour.

If you're used to the regular reports on securities owned by mutual funds, you'll find hedge funds less "transparent." It is hard to know what hedge funds actually own or how they make money from your money.

Mutual funds are marketed to the masses. They "democratize" stock ownership for small investors.

Hedge funds are the preserve of the wealthy or giant pension funds. The contradiction in hedge funds passing the US$1-trillion mark is that the hedgies are being forced to move down-market to keep growth going.

In this, they may be hoist on their own petard. If sold on exclusivity and above-average performance, it's a contradiction to make hedge funds available to the little guy.

They get around this by marketing "funds of hedge funds." An investor gets a piece of otherwise unavailable individual hedge funds -- albeit with extra fees heaped on top of fees.

However, the resulting performance, net of fees, will be comparable to ordinary government bonds. Of course, it's more fun to tell people at parties you own a hedge fund.

Mutual funds are supposedly "long-only" vehicles that make money when stock markets rise. Fortunately, they do 70% of the time.

Hedge funds are billed as "market neutral," supposedly generating "absolute performance" no matter how the market performs. That's because they can profit in bear markets by short-selling individual stocks or indices.

But this absolute performance is largely illusory. Technically, even bonds, treasury bills or GICs could also be described as absolute- return vehicles since they don't lose money (except to inflation, but let's not go there.)

Mutual funds are marketed by making media stars of the fund managers -- who eventually leave unitholders in the lurch when they go on to greener pastures. They are lured mostly by the green of hedge funds. Prominent Canadian stars who made such a leap include Veronika Hirsch and Frank Mersch.

Once they land, these stars get ownership in the new firm. They'll make so much money it's unlikely they'll quit. Few mutual fund managers are in that enviable position: Most are hired guns ready to move to the highest bidder for their services.

We'll give the last word to Rex Sinquefield, chairman of index mutual fund maker Dimensional Fund Advisors of Santa Monica, Calif., who once summed up for me the difference between the two investment vehicles: "Hedge funds are mutual funds for idiots." - In last week's column, due to an editing error, a quote about the costs of bridge should have been attributed to Ellen Pomer, Toronto-based founder of an online bridge training site at www.bridge-forum.com.