Term Paper: Hedge Fund and Mutual Fund in America Europe and Asia

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Mutual Funds and Hedge Funds in America, Europe and Asia

Mutual funds and hedge funds are part of a class of securities known as collective investment schemes. The basic premise of these schemes is that they allow investors the ability to invest in many different securities by purchasing just one. Each fund is essentially a financial intermediary. Groups of investors pool their money. The pool is managed by a professional, who takes the money and invests it in a range of securities. Each investor owns a unit of the fund, rather than the securities within the fund. The benefit is that the funds allow greater diversification than would be possible to the individual investor who would otherwise have to invest in each security on his or her own.

The Chinese market is burgeoning, but fraught with many challenges for would-be mutual and hedge fund managers. Savings rates are high and investors are risk averse, which is great for the mutual fund market. But the pool of available instruments is shallow, making it difficult to achieve superior returns. This shallow pool is only one of many problems inherent in setting up a hedge fund in mainland China, the other keys being lack of investor sophistication, weaknesses in the banking system and the dearth of fund management talent in Asia.

Mutual Funds

The term 'mutual fund' is the American name for a collective investment scheme. In most financial press, the term is globally understood. In Europe, other names are used to connote the same type of product. UCITS, short for Undertakings for Collective Investments in Transferable Securities, is the acronym for a legal status for collective investments that allows them to be marketed across Europe. In some countries, the term SICAV is also used. In some countries, the term 'managed fund' is preferred. In the UK, two terms are used interchangeably - OEIC and ICVC. OEICs have become popular in the UK, replacing unit trusts, which was the former preferred structure of collective investment in that country. There are sometimes slight differences in the manifestation of these products, so that whereas these terms, and the term 'mutual fund' have specific connotations in their countries, in most places 'mutual fund' is a generic term denoting any type of collective investment scheme.

The first mutual fund was founded in 1924 in the U.S. It was not until 1940 that legislation was enacted that gave mutual funds the form in which they are common today. Funds have proved exceptionally popular in recent years, growing from $48 billion in assets at the end of the 1960s to $12.356 trillion in assets today.

Mutual funds take many forms. One main division is between open-ended funds and closed-ended funds. An open-ended fund is one in which the fund remains open indefinitely to new capital. In this way, any investor can join the fund at any time. When new money is invested, new units are created to match the amount of the investment. The units remain a direct reflection of the underlying assets.

Closed-ended funds come with a fixed number of shares. These shares are typically issued as an IPO (initial public offering) and then traded through an exchange. There is an underlying value in the securities that the fund holds, but the price of the fund is not specifically related to that value, but rather due to supply and demand.

Mutual funds are a huge industry worldwide. Most funds have a focus. The focus can be either geographical (a Latin-America fund), based on industry (a technology fund) or even business characteristics (a small-cap fund or a growth fund). There are also funds that invest in securities other than stocks, such as money-market funds, bond funds and even funds of funds that invest in other mutual funds.

The main advantage of mutual funds is that they spread risk through diversification. By purchasing many different securities, the risk of any individual security losing money is offset by the likelihood that other securities will make money. Another advantage is reduced transaction fees. Each trade on an exchange costs money, so for an individual investor to acquire the securities in a given fund on their own would be prohibitively expensive. The cost of a mutual fund, in the form of a load (commission paid to the broker) and a management fee (paid to the fund manager) is much lower.

Hedge Funds hedge fund is another form of pooled investment. In the United States, hedge funds are subject to looser regulation by the Securities Exchange Commission and thus are not considered true mutual funds.

The creation of hedge funds is said to date to 1949. In essence, hedge funds are allowed to operate with looser regulation by limiting investment to qualified or "accredited" investors. So hedge funds are different from mutual funds in that they are not open to any investor. An accredited investor is typically one who can either demonstrate sufficient wealth to withstand the greater risk inherent in most hedge funds, or who can demonstrate a certain amount of knowledge and experience with securities markets. Aside from this, there is no set definition for the term 'hedge fund', although the term does carry essentially the same connotation worldwide.

There are a couple of other ways in which hedge funds differ from mutual funds. One is that whereas mutual funds are relatively liquid, hedge funds are often not. A mutual fund unitholder can sell a fund at any time, but hedge funds are often locked-in for a set period, and sales within this period are subject to a fee known as a surrender charge. Another key difference is that mutual fund prices are posted publicly each business day. Some hedge funds never post the value of their units, and those that do often do so only infrequently.

Hedge funds are distinguished by two things - their investment philosophies and their investment strategies. Many hedge funds seek to play a minority role in any given investor's portfolio (hedge funds will often form 5% of a total portfolio), with the objective of offsetting ('hedging') the risk that the investor has by way of their more standard market investments.

In terms of investment strategy, a typical mutual fund will invest in a specific instrument, usually either common stock or debt. Hedge funds frequently make use of far more sophisticated investment strategies, utilizing instruments such as short-selling, derivatives and futures. These sophisticated strategies form the core of the competitive advantage for many hedge funds. That said, most hedge funds are basic long-short funds, the bulk of their holdings being long or short equity positions.

Hedge funds have only one unifying feature, and that is that the compensation for the fund managers is incentive-based. That is, hedge fund managers take a portion of the profits for themselves. This typically ranges between 20-30% of profits, but can go as high as 50% for the industry leading funds. Further to this is the concept of a "high-water mark." This is when a fund manager does not receive performance fees unless the fund surpasses the previous highest level. This idea has come into place as a means to provide incentive to the fund manager to seek long-term gains, as opposed to engaging in high-volatility trading.

In light of that, there are dozens of types of hedge funds. Some of the basic ways in which hedge funds are broken down are by style, by market (i.e. equity, fixed income, commodities), by instrument (i.e. long/short, futures, options), exposure (directional or market neutral), by industry sector and by method. With respect to the latter, there are two forms - discretionary (managed by a fund manager) and systematic (managed by software). Some hedge funds are event-driven. These include funds specializing in distressed companies, merger arbitrage, and special situations. There are also hedge funds that specialize in owning other hedge funds.

Hedge funds are usually considered riskier investments than a typical mutual fund. There are several reasons for this. First, they are not subject to the same strict regulations as laid down by the SEC or other national securities regulator. This leads to looser controls and sometimes a lack of transparency. Many hedge funds are highly leveraged. This puts the investors' capital at greater risk. Short-selling is a common feature in hedge funds, and again increases the investors' exposure.

Hedge funds have, up until recent years, been primarily an American investment vehicle. The market in London was just $60 billion in 2002. That figure has exploded, however, to $400 billion today. New York and adjacent areas form the global center for hedge funds in terms of fund management (most of the world's funds themselves are technically based in the Caymans). London is the center for the industry in Europe, with about three-quarters of the business. The Asia region is headquartered in Hong Kong, with Singapore making inroads into the hedge fund business.

The Mutual Fund Industry - Success Factors

The two main success factors in the mutual fund industry are performance and marketing. Performance is… [END OF PREVIEW]

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