Unlike mutual funds whose activities are limited by a variety of government regulations, hedge funds may invest in virtually any opportunity in any market, and they may use derivatives, short selling, and leverage. This added flexibility allows them to take on more risk, or conversely to “hedge” against market risks. Some even aim to profit from downward-moving markets rather than upward-trending ones-something mutual funds cannot do.
Mutual funds charge fees based on the volume of assets they manage. This means they are paid whether they make money or not, and may therefore be tempted to focus more on gathering assets than on actual performance. Hedge funds benefit by typically weighting manager remuneration towards performance incentives, which means they not only have a much stronger interest in positive performance, but also that they can attract many of Wall Street’s most able individuals. Finally, unlike mutual funds, hedge fund managers invest a significant portion of their personal wealth in their own funds. Sharing in the risks as well as the rewards reinforces the manager’s vested interest to have exceptional performance.