Playing the Hedge Fund Craze

For investors worried about a so-called hedge fund bubble, that greater oversight can be reassuring, especially since hedge funds are well-known for their secrecy. And while there are redemption fees in most mutual funds, there are no lengthy lock-up periods as there are in many hedge funds. That freedom can come in handy in case of a problem.

In terms of style, many hedge funds seek to profit in all kinds of markets by using additional leverage and other speculative practices, like short-selling. These typically increase the risk of investment loss. Mutual funds, however, have traditionally been long-only vehicles designed for those uninclined to pursue sophisticated financial strategies.

Another major difference lies in fees. Hedge funds typically charge a hefty asset management fee of 1% to 2% of the assets, plus a "performance fee" of 20% of a hedge fund's profit. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating larger returns. On the contrary, mutual fund investors don't have to forfeit a portion of their gains even to the most successful manager. Meanwhile the average domestic equity mutual fund carries an expense ratio in the 1% to 3% range.

Finally, hedge funds typically require their investors to be accredited. Accredited investors are deemed by the SEC to be financially savvy enough to invest in hedge funds because they earn $200,000 a year or have more than $1 million in assets.

"An awful lot of younger investors are sophisticated about investing but may not be accredited and want access to hedge funds," says Jonathan Ferrell, portfolio manager for the $15 million TOPFXRock Canyon Top Flight fund, which employs hedge fund-style strategies. "Mutual funds with hedge fund properties offer that access."

Bridging the Gap

With the regulatory, strategy and fee disparities so wide, it's unsurprising that each side has been hesitant to bridge the gap. But mutual fund managers like Lee Schultheis of the ALPHXAlpha Hedged Strategies fund say that retail demand for products that are less exposed to changes in interest rates or equity markets is creating opportunities for both sides.