Mutual funds and hedge funds are very similar. An investor puts $10,000 into
a mutual fund or hedge fund, and the manager uses that $10,000—along with the
rest of the fund's capital—to buy and sell securities.
Though often shrouded in mystery, hedge funds are pretty easy to understand.
A mutual fund has to register with the Securities and Exchange Commission; a
hedge fund does not. Why? Hedge funds are exempt from registration because they
generally operate under one of two exemptions provided by the Investment Company
Act of 1940:
So...a hedge fund is little more than an unregistered mutual fund.
BUFFETT RAN A HEDGE FUND
In his early days of managing money, Buffett ran a hedge fund. His early
partnerships were not registered with the SEC, allowing him to operate with very
low overhead and a considerable amount of freedom.
At a minimum, registered mutual funds need boards of directors, exchange
registration, audited financials...the list is long and expensive. Though hedge
funds today are often seen as highfalutin, expensive operations, a hedge fund
can operate for just a few hundred bucks a year.
Take, for example, Buffett's early partnerships. He ran them from his house
for many years. Save the annual audit he opted to do for his investors, the cost
to run the Buffett partnerships was little more than the cost of the
transactions and Buffett's performance fee.
AREN'T HEDGE FUNDS AGGRESSIVE?
The term "hedge fund" is actually a gross misnomer. Today, any unregistered
mutual fund is termed a "hedge" fund; but, a hedge fund does not have to be
aggressive. In fact, I can start a hedge fund tomorrow and invest entirely in US
treasuries; or, I can invest entirely in GM...on margin.
Hedge funds are getting beat up in today's news, many for good reason. But,
not all hedge funds are aggressive, super-short, kill-the-markets funds.
THE "BUFFETT" HEDGE FUND VERSUS TODAY'S HEDGE FUND
Today's hedge fund typically charges a 2/20 fee—2% a year management fee and
20% of the profits above a certain level.
