Hedge funds intro | Finance & Capital Markets | Khan Academy

Summary

This video explains the key differences between hedge funds and mutual funds. Hedge funds are more secretive, unregulated by the SEC, and unable to market themselves to the public. Only accredited investors can participate. Hedge fund managers typically receive higher management fees and a significant percentage of the profits, often around 20%, creating a stronger incentive to actively manage the fund. In contrast, mutual fund managers are paid based on the fund's size, with less focus on performance. The video sets up a comparison of returns between hedge and mutual funds for the next discussion.

Takeaways

• 🔍 Hedge funds are often mysterious and can have a bad reputation due to secretive and sometimes strange activities.
• 📜 The key difference between hedge funds and mutual funds is that hedge funds are not regulated by the SEC.
• 🚫 Because hedge funds are not regulated, they cannot market themselves like mutual funds can.
• 📰 You won't see ads for hedge funds in financial magazines or on financial shows, unlike mutual funds.
• 💰 Hedge funds cannot take money from the general public; they can only accept investments from accredited investors.
• 🏦 To invest in a hedge fund, one typically needs a certain net worth, income, or level of sophistication.
• ⚖️ Mutual fund managers earn a percentage of the assets they manage, with a focus on growing the fund's size.
• 📈 Hedge fund managers are motivated differently, often earning 1% to 2% management fees and a percentage of the profits (typically around 20%).
• 💼 Some hedge fund managers earn significantly more than 20% of the profits, with successful ones receiving 25% to 30% or even more.
• 🔄 The next video will explore the mechanics of returns in hedge funds versus traditional mutual funds.

Q & A

What makes hedge funds different from mutual funds in terms of regulation?

Hedge funds are not regulated by the SEC, unlike mutual funds. This lack of regulation allows hedge funds more flexibility but also prevents them from marketing themselves to the public.

Why are hedge funds often seen as mysterious or secretive?

Hedge funds are perceived as mysterious because they do not market themselves publicly and often engage in complex or secretive market activities. Additionally, many people are unaware of the largest hedge funds due to their lack of public visibility.

Who can invest in hedge funds, and why?

Only accredited investors can invest in hedge funds. These investors need to have a certain net worth, income level, or sophistication to qualify, as hedge funds are not regulated by the SEC to protect less knowledgeable investors.

Why don't hedge funds advertise themselves like mutual funds?

Hedge funds cannot market themselves because they are not regulated by the SEC. This prevents them from advertising in financial shows or magazines, unlike mutual funds which frequently advertise.

How are hedge fund managers compensated differently from mutual fund managers?

Hedge fund managers are compensated by both a management fee and a percentage of the profits, typically around 20%. In contrast, mutual fund managers earn a fee based on the total assets under management, without receiving a share of the profits.

What is the typical management fee for hedge funds compared to mutual funds?

Hedge funds typically charge a management fee of 1% to 2%, sometimes more, while mutual funds charge around 1%. Hedge funds also take a percentage of the profits, which mutual funds do not.

How do hedge funds incentivize managers to outperform the market?

Hedge fund managers are incentivized to outperform the market because they earn a percentage of the fund's profits. This is different from mutual fund managers, who earn fees based on the size of the fund and have less incentive to beat the market.

Why can't hedge funds take money from the general public?

Hedge funds can't take money from the general public because they are not regulated by the SEC, and therefore, can only accept investments from accredited investors who meet specific financial or knowledge criteria.

What happens if a mutual fund doesn't perform well in the market?

If a mutual fund doesn't perform well, it risks losing assets as investors may withdraw their money. However, the managers still earn fees based on the remaining assets, giving them less incentive to actively beat the market.

What is the potential downside of hedge funds not being regulated by the SEC?

Since hedge funds are not regulated by the SEC, there is less oversight, which can lead to risky or secretive activities. This lack of regulation is one reason why hedge funds are often viewed with suspicion.

Outlines

00:00

🔍 Understanding Hedge Funds

The speaker introduces the concept of hedge funds, describing them as mysterious and often viewed with suspicion due to their secretive actions in the market. The primary distinction between hedge funds and mutual funds is that hedge funds are not regulated by the SEC, meaning they cannot advertise or take money from the general public. As a result, the largest hedge funds remain largely unknown to the public.

📊 No Marketing and Restricted Investors

Because hedge funds are not SEC-regulated, they cannot market themselves to the public. Unlike mutual funds, which are frequently advertised, hedge funds remain obscure, even though they may have strong track records. Furthermore, hedge funds can only accept investments from accredited investors—those who meet certain financial or educational thresholds, allowing them to invest in these unregulated financial vehicles.

⚖️ Hedge Funds' Manager Incentives

Another key distinction between hedge funds and mutual funds is how managers are incentivized. In mutual funds, managers are paid a percentage of the assets under management, encouraging growth in fund size rather than necessarily outperforming the market. In contrast, hedge fund managers are typically more motivated to generate profits since their compensation often includes a significant percentage of the fund’s profits.

💼 Hedge Funds' Fee Structure

The fee structure for hedge funds further differentiates them from mutual funds. Hedge funds tend to charge higher management fees, usually between 1% to 2%, compared to the lower fees of mutual funds. More significantly, hedge fund managers also receive a percentage of the profits, often around 20%, with top-performing funds sometimes demanding even higher cuts, up to 30% or more.

🔄 Comparison of Fund Types in the Next Video

The speaker concludes by announcing that the next video will cover the mechanics of returns in both hedge funds and traditional mutual funds, providing a comparative analysis of how both types of funds generate and distribute returns.

Keywords

💡Hedge Fund

A hedge fund is a type of investment fund that is more secretive and less regulated than mutual funds. Unlike mutual funds, hedge funds are not regulated by the SEC and cannot market themselves. They are typically accessible only to accredited investors. Hedge funds often engage in more aggressive investment strategies and managers earn a portion of the profits, aligning their incentives with the performance of the fund.

💡Mutual Fund

A mutual fund is a type of investment vehicle that pools money from the public to invest in stocks, bonds, or other securities. These funds are heavily regulated by the SEC and are widely marketed to the general public. The managers of mutual funds are paid based on the assets under management, not the profits generated, which means there is less incentive to outperform the market.

💡SEC (Securities and Exchange Commission)

The SEC is a U.S. government agency that oversees and enforces laws related to the securities industry, including mutual funds. In the context of the video, hedge funds are described as not being regulated by the SEC, which allows them to operate more secretively but also limits their ability to market and raise money from the public.

💡Accredited Investor

An accredited investor is an individual or entity that meets specific financial criteria, such as a high net worth or income, which allows them to invest in unregulated financial vehicles like hedge funds. In the video, it is explained that hedge funds are limited to accredited investors since they are not regulated by the SEC and involve higher risks.

💡Management Fee

The management fee is the percentage of assets that fund managers charge for managing an investment fund. In hedge funds, this fee tends to be higher, around 1-2%, compared to mutual funds where it's usually lower. The video contrasts the management fees of mutual funds and hedge funds, highlighting that hedge funds typically have more active management.

💡Profit Incentive

Profit incentive refers to the structure in hedge funds where managers are paid based on the profits they generate for the fund, typically around 20%. This is a key difference from mutual funds, where managers are paid based on the amount of assets under management, not on performance. This profit-sharing structure incentivizes hedge fund managers to actively manage the fund and aim for higher returns.

💡General Partner

In hedge funds, the general partner refers to the management company that operates the fund and takes a percentage of the profits. The video explains that general partners in hedge funds often get around 20% of the profits, incentivizing them to actively manage the fund for better performance.

💡Assets Under Management (AUM)

Assets Under Management (AUM) is the total market value of the investments that a financial institution or fund manager controls. In the context of the video, mutual fund managers are paid based on AUM, which incentivizes them to gather more assets rather than focusing on outperforming the market.

💡Track Record

Track record refers to the historical performance of a hedge fund or mutual fund. Although hedge funds often have impressive track records, they are not allowed to market themselves due to SEC regulations. This secrecy contributes to the mystery and suspicion surrounding hedge funds.

💡Sophistication

Sophistication, in the context of investment, refers to an investor’s understanding of complex financial instruments and markets. Hedge funds are limited to sophisticated investors, as defined by their financial education or experience, who do not need the SEC to 'watch their back' in investments. This is because hedge funds involve higher risks and less oversight.

Highlights

Hedge funds are often mysterious and sometimes have a bad reputation due to secretive practices.

The main difference between hedge funds and mutual funds is that hedge funds are not regulated by the SEC.

Hedge funds cannot market themselves or take money from the public.

To invest in a hedge fund, one must be an accredited investor with a certain level of wealth or sophistication.

Mutual funds are heavily marketed and widely known, unlike hedge funds.

Hedge funds are often more actively managed than mutual funds.

Hedge fund managers are typically compensated with a percentage of the profits, unlike mutual fund managers.

Mutual fund managers receive a percentage of assets under management, incentivizing them to grow the fund.

Hedge fund management fees are typically higher, ranging from 1% to 2%, sometimes more.

Hedge fund managers generally earn around 20% of the fund's profits, though it can be higher in some cases.

The structure of hedge funds creates more incentive for managers to outperform the market compared to mutual funds.

Mutual funds, by contrast, don’t offer the same profit-sharing model, which may reduce incentives for high performance.

Only accredited investors with a certain net worth or income level can invest in hedge funds.

Hedge funds remain obscure and non-household names because of their lack of advertising.

The next video will compare the mechanics of hedge fund and mutual fund returns.

Transcripts

In this video I want to see if we can understand

the idea of a hedge fund a little bit better.

And these tend to be pretty mysterious,

and sometimes get a bad name because some hedge funds do

do some fairly strange things and secretive things

in the market.

So people are, rightfully so, suspicious of many of them.

But the real difference between a hedge fund and the types

of mutual funds that we just talked about

are that they're not regulated by the SEC.

And because they are not regulated

they can't market themselves.

That's why when you watch financial shows,

or you get a magazine, a finance magazine

you will not see ads for hedge funds.

The mutual funds are all over the place,

marketing them left and right.

Hedge funds the largest hedge funds in the world

are definitely not even household names.

Very few people even know what those largest hedge

funds in the world are.

And that's because they can't market themselves.

No matter how good of a track record,

or really how reasonable of a fund

they might be-- some might not be reasonable, some are--

they can't market themselves.

And they also can't take money from the public.

So in general, in order to invest in a hedge fund,

you have to be an accredited investor, which

means you have a certain net worth,

or maybe you have a certain income,

or maybe by virtue of your education

you can prove that you have a certain level of sophistication

to invest in these things that aren't regulated.

You, I guess, don't need the SEC to watch your back.

So the regulation is a key difference.

Marketing, no money from the public.

And then the other key difference

is how the managers tend to be incented.

I know incented is not a word, or motivated.

In the mutual fund world, managers

get a percent of assets.

So for mutual fund manager, larger is better.

The more under management the more money

the mutual fund manager's going to make.

So they really just want to keep marketing it, marketing it,

marketing it.

They don't get a cut of the profits.

So you really there's not a lot of incentive to kind of really

beat the market here.

Because if they kind of don't be the market one year, then

all of a sudden, their fund will shrink.

So they really just get a fee on the size of the fund.

In a hedge fund, and usually the implication

is that a hedge fund will be more actively managed,

they'll get a larger management fees.

So larger management fee, instead of the 1%, 1%

is actually a lot for mutual fund.

Instead of that, hedge funds tend to be 1% to 2%.

So 1% to 2% management fee, and sometimes even larger

than that.

But the even I guess bigger difference,

and this is where hedge funds are

very different from a traditional mutual fund,

is that the management company, the general partner,

gets a percentage of the profits.

So with a hedge fund manager or the management company,

the going rate tends to be about 20$ of the profits of the fund.

Sometimes it's less, sometimes it's a lot more.

Some very successful hedge funds get 25%, 30% or even

a larger percentage of the profits.

So with that out of the way in the next video,

I'm going to do some different mechanics of essentially

the same returns, but one by hedge fund

and then one by a traditional mutual fund.