About Hedge Funds - Advantages of Hedge Funds over Mutual Funds

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Advantages of Hedge Funds over Mutual Funds

Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds, which have SEC regulations and disclosure requirements that largely prevent them from using short selling, leverage, concentrated investments, and derivatives.

This flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks.

The strong results can be linked to performance incentives in addition to investment flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily invested in a significant portion of the funds they run and shares the rewards as well as risks with the investors. "Incentive fees" remunerate hedge fund managers only when returns are positive, whereas mutual funds pay their financial managers according to the volume of assets managed, regardless of performance. This incentive fee structure tends to attract many of Wall Street’s best practitioners and other financial experts to the hedge fund industry.

In the last nine years, the number of hedge funds has risen by about 20 percent per year and the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated to be approximately 8350 hedge funds managing $1 trillion. While the number and size of hedge funds are small relative to mutual funds, their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors.

Hedge Funds Outperform Mutual Funds in Falling Equity Markets

	S&P 500	VAN U.S. Hedge Fund Index	Morningstar Average Equity Mutual Fund
1Q90	-3%	2.20%	-2.80%
3Q90	-13.70%	-3.70%	-15.40%
2Q91	-0.20%	2.30%	-0.90%
1Q92	-2.50%	5.00%	-0.70%
1Q94	-3.80%	-0.80%	-3.20%
4Q94	-0.02%	-1.20%	-2.60%
3Q98	-9.90%	-6.10%	-15.00%
3Q99	-6.20%	2.10%	-3.20%
2Q00	-2.70%	0.30%	-3.60%
3Q00	-1.00%	3.00%	0.60%
4Q00	-7.80%	-2.40%	-7.80%
1Q01	-11.90%	-1.10%	-12.70%
3Q01	-14.70%	-3.80%	-17.20%
2Q02	-13.40%	-1.40%	-10.70%
3Q02	-17.30%	-3.60%	-16.60%
3Q04	-2.30%	1.40%	-1.70%
1Q05	-2.59%	.10%	-2.20%
Total	-113.01%	-10.30%	-115.70%

During the last 18 years, the S&P 500 Index has had 17 negative quarters, totaling a negative return of 113.01%. During those negative quarters, the average U.S. equity mutual fund had a total negative return of 115.7%, while the average hedge fund had a total negative return of only 10.3%, displaying the ability of hedge funds to preserve capital in falling equity markets.