The future performance of Mutual Funds is dependent on the direction of the equity markets. It can be compared to putting a cork on the surface of an ocean - the cork will go up and down with the waves.
The future performance of many Hedge Fund strategies tends to be highly predictable and not dependent on the direction of the equity markets.
It can be compared to a submarine traveling in an almost straight line below the surface, not impacted by the effect of the waves!
There are mainly four key distinctions:
1. Relative Performance:
Mutual Funds are measured on relative performance. Their performance is compared to a relevant index such as the S&P 500 Index or to other Mutual Funds in their same sector.
Hedge Funds, on the other hand, are expected to deliver absolute returns by attempting to make profits under all circumstances, even when the relative indices are down.
Mutual Funds are highly regulated, restricting the use of short selling and derivatives. These regulations serve as "handcuffs," making it more difficult to outperform the market or to protect the assets of the Mutual Fund in a downturn.
Hedge Funds, on the other hand, are unregulated and therefore unrestricted. They are allowed to short sell and are able to use many other strategies designed to accelerate performance or reduce volatility.
However, an informal restriction is generally imposed on all Hedge Fund managers by professional investors who understand the different strategies and typically invest in a particular Fund because of the manager's expertise in a particular investment strategy.
These investors require and expect the Hedge Fund to stay within its area of specialization and competence. Hence, one of the defining characteristics of Hedge Funds is that they tend to be specialized, operating within a given niche, specialty or industry that requires a particular expertise.
3. Management Renumeration:
Mutual Funds generally remunerate management based on a percent of assets under management.
Hedge Funds always remunerate managers with performance-related incentive fees as well as a fixed fee.
Investing for absolute returns is more demanding than simply seeking relative returns and requires greater skill, knowledge, and talent.
Not surprisingly, the incentive-based performance fees tend to attract the most talented investment managers to the Hedge Fund industry.
4. Protection Against Declining Markets:
Mutual Funds are not able to effectively protect portfolios against declining markets other than by going into cash or by shorting a limited amount of stock index futures.
Hedge Funds, on the other hand, are often able to protect against declining markets by utilizing various hedging strategies.
The strategies used, of course, vary tremendously depending on the investment style and type of Hedge Fund.
But as a result of these hedging strategies, certain types of Hedge Funds are able to generate positive returns even in declining markets.