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5/25/2005
Mutual Funds vs. Hedge Funds, by Philip J. McDonnell

Recently there has been a great deal of negative talk about hedge funds. Supposedly some big fund is ins trouble because of its trading in GM. Out of 8000 funds it would be surprising if none of them lost any money on GM. The entire campaign has been conducted via rumor and innuendo. No facts have come forth, only accusations and suspicions.

This underscores some fundamental differences between the mutual and hedge fund industries. Some think the line between the two has blurred. Hedge funds use leverage, futures, derivatives and other exotic trading vehicles. Many mutual funds do as well. The real difference is in the fees and the management incentive structure.

Mutual funds argue that their fixed annual percentage of assets is ideal for the client because their managers are motivated to practice conservative policies which will preserve assets for both the client and the fund. Hedge funds are typically compensated with an annual fee plus an incentive from 20 to 25% of profits. Hedge fund managers argue that the best managers move to hedge funds because they are paid better.

Regardless of which argue rings true for you there is an inescapable point to be made. Mutual funds don't particularly care about costs to the fund which are relatively small relative to assets but large relative to return. Managers care mainly about asset size of the fund. The easiest way to increase asset size for an open ended fund is through sales to new investors. This is the job of the brokerage industry.

There exists a long standing symbiotic relationship between the mutual fund industry. The brokers expect the fund to give them commission business and the fund expects the broker to sell their fund shares to new customers. This is the main reason that mutual fund managers don't care about commission costs. The more they spend in commissions the more new money comes in. New money is the fastest way to increase the size of their fund assets. This phenomenon also helps explain why mutual funds consistently under perform the market averages.

It also accounts for the war of words against the hedge fund industry. The mutual funds enjoy a very profitable relationship within the status quo. The recent rise of hedge funds with their performance based incentives is inimical to the way business is done in the mutual fund industry.