In the battle of mutual funds versus hedge funds, who has the upper hand? Let's compare them…
One large difference between both is ownership structure.
Investors in a mutual fund don't own the investments made in the fund directly. Instead, they own shares of the fund itself, which gives them a proportionate share of the gains and losses realized by the manager.
Investors in managed accounts, on the other hand, have direct ownership of the investments the manager is making. The portfolio manager trades one large pool of individual accounts as if they were one, using special software and technology that makes this possible. Direct ownership is a great advantage of the managed model.
The fact that mutual funds are actual companies that clients invest in by owning their shares, makes it possible for the fund entity itself to go bankrupt, leaving investors in the dust. Score: Managed Accounts 1 vs Mutual Fund 0.
Benefits of Managed FX versus Mutual Funds
FX portfolio managers specialize in the trading of currencies. Because currencies as an asset class have many inherent advantages, these advantages carry over to managed accounts as well.
Currencies can be traded 24 hours a day (from Sunday afternoon to Friday afternoon New York time), so they allow for a more continuous form of operation or money management. This is not the case for the stocks and bonds purchased within mutual funds, which exhibit an additional risk: the risk of price gaps because the market closes and reopens over 12 hours later every day and no trading can take place during those "dead" periods.
The currencies market is also the most liquid market in the world, exhibiting a daily volume of about US$4 Trillion in 2010 (see "What is the Size of the Managed Account Market?"). This extreme level of liquidity means that a talented money manager can get in and out of larger positions quickly whenever he wants. This is much more difficult for a mutual fund manager to do at a moment's notice, without significantly affecting the market price, especially if he has accumulated a substantial position in a stock or security.
Consequently, managed FX becomes a more flexible investment vehicle than mutual funds. Score: Managed Accounts 2 vs Mutual Fund 0.
Historical Volatility Comparison
There's a big misconception in the traditional investment community when it comes to stocks versus forex. Many investors have been led to believe that stocks are the best "long term" investment out there, while investments like forex are "riskier" in nature and used primarily by "short term" speculators. But reality tells a different story.
If we use the traditional definition of risk as the volatility of returns and do a historical comparison of asset classes, currencies have demonstrated lower volatility (or "risk") than traditional asset classes, such as stocks and bonds.
The graph below compares the volatility of currencies (Deutsche Bank's CVIX index) versus stocks (VIX, volatility of the S&P500 stock index).1 The much lower numbers on the right vertical scale of the image indicate that the volatility of currencies is a lot lower than that of stocks.
These results are startling and demonstrate that mutual funds, which trade stocks and bonds, can be a lot riskier than asset classes that are misperceived and undiscriminatingly categorized as "risky," such as forex, the key asset class in the managed FX world.
The traditional investment industry (including mutual fund vendors) has been brainwashing investors for over 50 years with this overly simplistic "long-term-vs-short-term" argument…But is is nothing but a myth!
The reality is that you don't get to enjoy the "long term" unless you take care of the "short term." A huge number of mutual fund investors who just took a relax-and-sit-back approach to mutual fund investing in the last 10 years have had a rude awakening – witnessing their fund managers steer their portfolios to losses of 50% or more. Many investors have had to modify their game plan, either prolonging their planned retirement dates or going back to work due to a decade of wealth market evaporation (thanks to their fund managers!). Score: Managed Accounts 3 vs Mutual Fund 0.
Misaligned Interests – Mutual Fund Manager Compensation
Despite the sub-par performance of mutual funds historically, fund managers have continued to make millions. Even before this decade of market bloodshed began, funds have historically under-performed stock market averages and yet experienced continuous growth in assets.
This is not surprising, given the fact that the public has been sold the idea that this sub-par environment is an acceptable norm.
Due to investor complacency, most mutual fund managers have adopted a methodology that involves the inactive "hoarding" of an endless number of stocks. This "lazy boy" approach includes the complete shunning of a more active, hands-on method of "shorter term" trading, since it jeopardizes the status quo that spits out their big, fat paychecks. Think about it….Why would they risk their salaries by making a mistake while employing methods outside of the accepted "norm?" Isn't it better to just sick back, relax, and enjoy the ride?
In comparison, a forex managed account manager cannot afford that luxury. On the contrary, he is on the front line every day focusing on the "short term" in an attempt to avoid falling into the same "average" environment so many mutual fund managers embrace. As a result, managed accounts tend to be a lot more actively managed than funds. But "why," you ask? Why do FX money managers bust their arses so much to perform? It's quite simple…their compensation depends on it. All or the significant part of what these managers make is based on the profits they generate. No profits = No Lobster Bisque!
And so our game comes to an end.
Drum roll……Final Score: Managed Accounts 4 vs Mutual Fund 0 (we could have run up the score further, but we are good sports!).
- Deutsche Bank AG. Deutsche Bank Guide To Currency Indices. October 2007.