Blog Post from September 23, 2023 by Bart DeCanne
Hedge Fund vs Mutual Fund vs Managed Account

Ever wondered how a hedge fund compares to a managed account or a mutual fund? We explain...

Many of our current investors and future prospects are familiar with the concept of a managed account, but not necessarily a hedge fund. So the question often arises how both compare. And why is a hedge fund not a mutual fund? This blogpost attempts to cover some key differences.

Entity and account structure

A separate account is often named a separately managed account (SMA), separate account or private account when opened with investment management firms. An SMA is typically managed by outside money management (a registered investment advisor or wealth manager). So it can be seen as an investment vehicle similar to a mutual fund, in which the customer pays a fee to a money manager for services to manage the customer's investment.
The difference though is that a mutual fund investor owns shares of a company that in turns owns other investments, whereas an SMA investor owns the invested assets directly in his own name.

The traditional advantage of an SMA vs a mutual fund is a higher degree of freedom of investments (eg mutual funds cannot take short positions). But even for the same investments as a mutual fund, an SMA has 2 key advantages vs a mutual fund:

• a mutual fund investor can have a tax liability when the fund sells investments for a gain prior to the investor stepping into the mutual fund ('unearned capital gain')

• the investor does not have discretion over the investments of the mutual fund.

Let's turn now to a hedge fund to make the comparison. A hedge fund investing in publicly listed financial instruments typically uses a pooled investment account i.e. all assets of the fund are contained within a single brokerage account, and a third-party fund administrator calculates the relative portion attributable to each investor, and provides periodic account statements to each investor.
As the hedge fund is organized as a limited partnership, which is a pass-through entity for taxation, the tax liability flows to each investor, not to the fund, and thus each investor only pays taxes on his own capital gains from the time he enters the fund. So the taxation argument in favor of an SMA vs a mutual fund doesn't apply to a hedge fund.

The other argument in favor of an SMA does not either since a hedge fund follows a proprietary trading strategy over which the individual investor cannot exercise any discretion.

Compared to a mutual fund, a hedge fund is subject to less trading restrictions. Many hedge fund strategies could not be done in a mutual fund. But on the flip side, a hedge fund is only available to a more limited set of investors. Both are explained more later in this post.

Finally we should also note that because of the usually opaque trading strategy of a hedge fund, the use of a single pooled investment account also ensures that each investor receives the same gross percentage returns (net returns may be different due to possible special arrangements with each investor disclosed in a so-called 'sideletter'). By construction, the fund manager cannot make different investment decisions between investors and e.g. expose some investors to more risky trades. Since in many cases the Fund Manager and affiliated parties hold a significant percentage of the fund's assets, this is an extra assurance to external investors that no outsize risk is being taken with their invested money as the fund manager(s) have their own skin in the game, and at the same risk level.

Fee structure

A managed account typically uses a fee structure that scales with the NAV (net asset value) of the account.Thus the fee does not directly depend on the performance of the account as there is no profit sharing component (of course indirectly it does as NAV will grow more with a higher return). This is considered as protecting the investor against risky behavior by the portfolio manager.
An annual management fee of 0.5 to 1.3% of account NAV, charged in advance per month or per quarter, is typical with that percentage usually scaling down with higher account value, and with robo-style trading.

A hedge fund on the other hand has, next to a management fee, also a profit sharing or 'incentive allocation' (IA) fee as a percentage of the gross gains of the account. It may be charged only quarterly in arrears based on performance of the most recent quarter (to smoothen out some performance fluctuation within a quarter).

Furthermore typically a 'high watermark' protects the investor via a loss-carry forward provision that precludes the fund from charging IA as long as a loss in one or more prior periods is not fully recuperated. This avoids that the fund would be able to charge IA multiple times on the same profits over multiple periods.

A typical fee structure for a hedge fund is the so-called '2&20', meaning a 2% annual management fee and a 20% incentive allocation with high watermark. This is also the fee structure of the Class-A shares of our OptionAgent Capital Partners LP hedge fund.

Investor qualification/minimum investment

Because of a hedge fund's fee structure that includes a profit sharing component, and possibly the more risky investment strategies pursued (see later), the SEC deems an investment in a hedge fund only suitable for investors that are more financially savvy, and they consider an investor's net worth a good proxy for that. As a result, an investor in a hedge fund needs to meet the SEC's 'Accredited Investor' test.
For individual investors this means currently an annual income of $200K per year (or $300K together with a spouse) OR a net worth, excluding your primary residence (meaning: do not include the equity in your home, but also not the mortgage liability), of $1M.

An Accredited Investor may invest in a hedge fund but cannot be charged a variable performance fee (so no profit sharing fee, only a management fee). To allow a profit sharing fee, the requirement is that the investor passes the 'Qualified Client' test, which roughly doubles (a little more actually due to inflation adjustments) the net worth ex-primary residence requirement to $2.2M, and there is no income-only based alternative.

The OptionAgent fund's class-A shares (with the 2&20 fee structure explained earlier) are therefore only available to Qualified Client investors. However there is an alternative to waive this test if a large amount of money is invested in the fund (the details of this fall outside the scope of this post).
Also, based on the SEC rules under which our fund is setup, the burden is on us to do reasonable efforts to verify that investors in our fund meet these income or net worth requirements.

Minimum investments can vary significantly between hedge funds. Our fund has a minimum $200K commitment.
In contrast a managed account investor does not have a legally required minimum income or net worth requirement, but there will likely still be a minimum investment commit.

Investment strategies

Because of the lesser regulation vs mutual funds, and the active proprietary trading strategies pursued by their fund managers, hedge funds offer a wide range of investment vehicles. They may pursue leverage, derivatives (as our OptionAgent fund which exclusively invests in financial options), and take short positions in stocks.
Another strategy may be event-driven in which positions are taken e.g. in distressed companies betting on a turnaround, or based on macro-economic events.
Hedge funds may offer long/short equity strategies depending on future market conviction, or be market neutral. Our OptionAgent strategy is aligned with the latter, as we aim to provide positive returns in both up- and down-markets.

On the other hand the money manager of a managed account will obtain an investor profile to determine, amongst other factors, a 'risk tolerance' level and invest in a collection of instruments that are deemed suitable. The investment could be a choice between standard portfolios maintained by the firm, or be more personalized (for larger managed accounts).

Liquidity and account updates

When a managed account only invests in stocks, bonds or ETFs for which daily, and intra-daily, valuations are available, and since each investor holds assets in a separate account, account NAV can be updated at least daily.
For a hedge fund, with a single pooled investment account, and (manual) periodic accounting to determine overall fund expenses and an allocation of fund net income between fund investors, that is usually not the case. Total fund and each investor's account NAV is then only updated periodically (in our fund, once per month).

Furthermore a hedge fund's proprietary trading strategies may take some time for gains to materialize. Therefore in many cases there is a liquidity limit expressed as an initial hold period, and restrictions on when capital can be withdrawn. But they are typically not as illiquid as private equity (eg. venture capital, or real-estate) funds where it may take several years before an investor can do a redemption.
Our OptionAgent fund applies only an initial 180-day hold period from the date the account was opened, and restricts capital withdrawals to the end of each quarter, with a 30-day notice.

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