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Chapter 4. Mutual Funds and Hedge Funds

Mutual funds and hedge funds invest cash on behalf of individuals and companies. The funds from different investors are pooled and investments are chosen by the fund manager in an attempt to meet specified objectives. Mutual funds, which are called "unit trusts" in some countries, serve the needs of relatively small investors, while hedge funds seek to attract funds from wealthy individuals and large investors such as pension funds. Hedge funds are subject to much less regulation than mutual funds. They are free to use a wider range of trading strategies than mutual funds and are usually more secretive about what they do.

This chapter describes the types of mutual fund and hedge fund that exist. It examines how they are regulated and the fees they charge. It also looks at how successful they have been at producing good returns for investors.

4.1 Mutual Funds

One of the attractions of mutual funds for the small investor is the diversification opportunities they offer. As we saw in Chapter 1, diversification improves an investor's risk-return trade-off. However, it can be difficult for a small investor to hold enough stocks to be well diversified. In addition, maintaining a well-diversified portfolio can lead to high transaction costs. A mutual fund provides a way in which the resources of many small investors are pooled so that the benefits of diversification are realized at a relatively low cost.

Mutual funds have grown very fast in since the Second World War. Table 4.1 shows estimates of the assets managed by mutual funds in the United State since 1940. These assets were over $10 trillion by 2008. About 50% of US households own mutual funds. Some mutual funds are offered by firms that specialize in asset management, such as Fidelity. Others are offered by banks such as J.P. Morgan Chase. Some insurance companies also offer mutual funds. For example, in 2001, the large US insurance company State Farm began offering ten...