Investments

What Is A Hedge Fund vs Mutual Fund

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 11 minute read

When meme stocks took off in 2021 and retail investors triggered large short squeezes to pull these big-money firms out of their investments, hedge funds became a hot topic of discourse. Several large players in the stock market lost millions of dollars while many little investors gained.

Hedge funds have historically been a promising investment option for those who meet the necessary criteria, typically outperforming widely followed benchmarks by a significant margin. 

At first glance, there doesn’t seem to be much of a difference between them and their mutual fund ancestors. However, could you please explain the distinctions? Who, then, would do well to put their money into either one, both, or a hybrid of the two?

The differences between mutual funds and hedge funds

Hedge funds and mutual funds initially appear to be comparable investment instruments. They both collect money from a sizable number of investors, pool it, and use it to make significant investments that will yield returns for their shareholders.

Both of them offer portfolios that are rather well-diversified and do the bulk of the work-saving for investors. But the similarity between these two kinds of investments ends there. The two types of funds are so different from one another that comparing them becomes impossible as you learn more about them.

Hedge FundsMutual Funds
ReturnsBelieved to generate higher returns than widely accepted benchmarks. Acceptable returns are believed to be lower than hedge funds. 
RiskHigher risks due to the use of derivatives and unorthodox strategies.Lower risk due to regulation, diversification, and reliable management.
AvailabilityOnly available to accredited investors. Widely available to institutional investors, retail investors, and accredited investors. 
Management FeesHigher management fees. Lower management fees. 
LiquidityLower liquidity.Higher liquidity. 
Management StyleActively managed. Actively or passively managed depending on the fund. 

Investment Method

When putting money into a fund that is not directly managed by you, it is important to learn as much as possible about the investment methods the fund uses. 

When comparing hedge funds and mutual funds, you will see that they take very different approaches to invest. What follows is a comparison of the various investment approaches taken by these institutions.

Strategy for Investing in Hedge Funds

Real estate, stocks, derivatives, foreign currency, and more are just some of the many assets that hedge funds can put money into. These funds are notorious for engaging in high-stakes, high-risk investment and trading strategies, such as the use of derivatives and margin trading. 

Such funds may engage in short selling to profit from a decline in stock prices, for instance when the market is down or a firm announces bad news. Hedge funds are in business to make money, and if that means taking on substantial risk, then that’s what they’ll do.

Strategy for Investing in Mutual Funds

Mutual funds use less complex and risky investment methods and are thus simpler to understand and work with. Mutual fund managers adopt low-risk strategies that heavily diversify their holdings, so they are widely believed to be safe bets for investors. 

A few of the most typical methods employed by mutual funds are:

  • Indexing is the process of trying to imitate the performance of a widely followed stock market or industry index.
  • Investing in stocks that are now trading at a discount to their rivals’ values in anticipation of a strong recovery is known as value investing.
  • Investing in companies that have a track of consistent revenue, earnings, and stock price growth is known as growth investing.
  • When you invest in equities with a high dividend yield, you’re engaging in income investing.

Management Approach

For two reasons, a fund’s management approach is crucial. First, the costs associated with investing strategies that demand more management effort are often higher.

Additionally, it is important to take into account the increasing hazards of human mistakes that occur with active management.

Management Style of Hedge Funds

To capitalize on the market and non-market possibilities, hedge fund managers and their teams of traders and analysts are actively managing their funds. 

These groups are notorious for their unconventional and occasionally high-risk approaches to investing and managing funds, which frequently involve the use of derivative investments and alternative investments in off-market assets like fine art, wine, and essentially anything else with the potential to increase in value.

Management Style of Mutual Funds

Actively managed and passively managed mutual funds both exist. 

How each choice operates is as follows:

  1. Funds With a Proactive Investment Strategy. Professional fund managers, teams of traders, and teams of analysts oversee actively managed mutual funds. This group is very hands-on, doing research and trading securities frequently to try to outperform market averages for their investors utilizing the methods specified in their prospectus.
  2. Funds with minimal human intervention. Mutual funds that are passively managed attempt to mimic the performance of a predetermined index. They accomplish this by purchasing stocks in all of the companies that make up the benchmark. These funds often have lower cost ratios since they don’t employ a professional fund manager to source and analyze investment possibilities or handle day-to-day trading.

Investors who qualify

Both mutual funds and exchange-traded funds differ greatly in this regard. In the end, mutual funds are much more approachable than hedge funds. For the following reasons:

Investors Who Qualify for Hedge Funds

In the United States, hedge funds are subject to Regulation D of the Securities Act of 1933 because they are private investment firms. According to this rule, only accredited investors may contribute money to private investments.

To put it another way, if you don’t fit one of the following categories, you shouldn’t even think about investing in a hedge fund.

  • Wealthy people. You’re worth at least a million dollars.
  • People with a lot of money. You’ve averaged over $200,000 in annual salary for the past two years, and this year should be no different.

Investors who Qualify for Mutual Funds

Mutual funds are made to accommodate a wide variety of investors. You can invest in these funds if you have a high net worth or a low net worth, or if you are a retail investor, an institution, or a high net worth individual.

Types of Assets

The level of danger associated with various asset types varies widely. Portfolios of each fund type typically comprise items from the following categories:

Classes of Hedge Fund Assets

A hedge fund may put its money into a number of different types of assets. Traditional securities such as stocks and bonds aren’t the only things they invest in; they also put money into other assets such as land, real estate, currencies, and derivatives.

A hedge fund may invest in almost any type of security. There is no reluctance to make an investment if the fund management is confident that it will yield a satisfactory return.

Classes of Mutual Fund Assets

Mutual funds’ investments tend to be more staid than those of ETFs and IPOs. Stocks and bonds are the most common types of marketable assets that people invest in. A tiny number of specialized mutual funds may employ leverage or make investments in alternative securities, but this is not common practice.

Liquidity

Shares of investment are said to be highly liquid if buying and selling them is quick and simple. Investments with high liquidity are simple to acquire and simpler to liquidate when the time comes. Investments with limited liquidity may make it tough to sell at the precise moment you choose.

Liquidity for Hedge Funds

It’s not always possible to withdraw money from a hedge fund. It’s common for these funds to have lengthy lockup periods, during which investors can’t touch their money for a long time.

When it comes to liquidity, hedge funds might lock it for a number of reasons, even after the lockup period has passed.

In the case of a bad market or high volatility event, for instance, the fund manager may elect to lock redemption in order to safeguard investors against a broad selloff in the portfolio. While this provides some measure of safety, it also severely restricts the marketability of these investments.

Liquidity for Mutual Funds

Investors in mutual funds have access to a considerably larger pool of liquid assets. An investor can typically withdraw their funds from security within a single trading day. 

While that leaves you vulnerable to a sharp decline in the value of your fund’s holdings, it ensures that your money will be there whenever you need it.

Fees and Requirements

When investing, it is crucial that you keep an eye on the costs involved. Each fund has its own management charge, and paying too much of it might significantly reduce your returns. 

To be sure you can afford the initial expenditure required to participate in a fund, it’s wise to check its minimum investment requirement.

Fees for Hedge Funds

Hedge funds typically have far higher fees than other investment-grade funds due to their high levels of activity and the costs associated with the diverse variety of derivatives and other asset classes they use.

Management costs for hedge funds are typically between 1 and 3 percent of AUM, like those of many mutual funds. However, unlike other funds, hedge funds typically impose performance fees of 10% to 30% of the fund’s profits. 

The 2-and-20 fee structure is widely used in the hedge fund industry. Under this structure, the hedge fund would charge its investors 2% annually and keep 20% of any gains it made above a certain benchmark.

Hedge funds have a lot of leeways to play with and can provide high returns, but many experts claim they are not worth the money because of the excessive fees they impose.

In addition, low initial outlays can be discouraging. These funds will typically have a minimum investment requirement of at least $100,000. The price of entry might range from zero to one million dollars.

Fees for mutual funds

Mutual fund expenses are typically simpler to grasp and control. An expense ratio is provided for these funds, which measures the yearly charge against the total value of the investment. 

Expense ratios for mutual funds often fall within the range of 0.25 percent to 1.5 percent. For investors with a $10,000 portfolio, the annual management charge will be between $25 and $150.

Mutual funds have much lower minimum investment requirements compared to their hedge fund counterparts. The typical initial investment range for a mutual fund is between $1,000 and $5,000.

By opting for ETFs, regular investors can avoid even these low entry requirements and transaction costs (ETFs). In addition to lowering the barrier to entry to the purchase of a single share, ETFs typically have far lower costs than either of the aforementioned choices. 

The annual expense ratio (TER) of some exchange-traded funds is only $3 for $10,000 invested (0.03%).

Performance

It is important to consider returns whenever making an investment. Ultimately, your goal is financial success. Compare these two sorts of investments.

Hedge Fund Results

The widespread consensus among hedge fund investors is that these funds outperform other investment options in terms of returns. The evidence disproves this widespread assumption. Take a look at the chart below, which contrasts the S&P 500’s results with those of the HFRI 

Fund Weighted Composite Index, an index that measures the overall performance of hedge funds:

One-Year ReturnsThree-Year ReturnsFive-Year Returns
S&P 50040.84%21.46%116.6%
HFRI hedge fund index11.13%10.05%7.64%

You can see that the S&P 500 has overwhelmingly outperformed hedge funds’ typical returns over the previous five years by all relevant metrics. 

That implies hedge funds aren’t worthwhile investing your time in, but it’s critical to remember that the statistics presented above is an average. Although they are few and far between, some hedge funds have a history of outperforming market averages.

Even though the majority of individual funds underperform on average, wealthy investors continue to pour money into hedge funds because they are looking for firms with high performance.

Mutual Fund Results

On the other side, mutual funds make more reasonable return projections, and they tend to be accurate. If a mutual fund’s prospectus states that it will attempt to achieve performance levels similar to those of the S&P 500 Index, then it is quite likely that it will do so.

Numerous funds aim to duplicate the performance of the market as a whole. It’s vital to remember that the performance of actively managed funds will hinge primarily on the skill of the management staff.

Before investing in a fund, it’s usually a good idea to research its track record in comparison to relevant benchmarks.

Regulation

Investors have some security from regulations. To ensure the safety of its investors, a tightly regulated fund must adhere to a strict set of standards, while less stringently controlled funds can bend or break the laws as they see fit. 

In order to compare the two, consider the following:

Hedge fund regulation

When compared to public investments, the SEC’s involvement in private ones is noticeably lower. Hedge funds have light oversight since they are classified as investment companies.

Hedge funds can invest their clients’ money across a wide variety of risky assets because of the absence of regulation in this industry. Furthermore, this is why only accredited investors can participate in these funds.

Mutual fund regulation

Mutual funds are restricted to investing in publicly listed securities like stocks and bonds. Investors are shielded against catastrophic losses brought on by fraud, illegal practices, or questionable high-risk investments by the stringent rules and regulations in place.

Should You Choose Mutual Funds or Hedge Funds?

The million-dollar question is this. Which kind of investment fund should you pick? What you should think about is this:

Hedge Funds Are for You If…

As a result of their high costs, high levels of risk, and poor track records, hedge funds are rarely the best option. Hedge funds aren’t always the best option, but in one case they might be the best decision.

Hedge funds are perfect for the ultra-wealthy who aren’t afraid to roll the dice in pursuit of huge returns. However, before putting your money into any hedge fund, you should do your homework. 

Keep in mind that, on average, hedge funds can’t even match the market’s returns, let alone outperform them. You are on the hunt for a rough diamond.

Mutual Funds Are a Good Investment If…

Mutual funds are a superior option for most investors. Mutual funds are the most suitable investment vehicle for the common person who does not have hundreds of thousands or millions of dollars lying around.

You may be wealthy enough and meet the criteria for participation in hedge funds, but it doesn’t mean you have to. Mutual funds are the best choice if you want your returns to closely track those of the market while yet being subject to managing risk.

Both are wondering if…

Only in exceptional cases is a portfolio that includes both mutual funds and hedge funds the best option. You can reduce your overall risk exposure as an accredited investor by spreading it over multiple asset classes, such as mutual funds and hedge funds.

Mutual funds are known for their steadiness, while hedge funds can provide a dose of high-risk, high-reward investing.

Bottom Line

Overall, mutual funds and hedge funds are two quite different investment vehicles. Mutual funds have a longer track record of success than hedge funds, and they are much more easily accessible to the average investor due to their lower fees and higher transparency.

No matter what route you take, it’s vital that you have your facts straight before making any financial commitments. Don’t put your trust and money into something you don’t fully understand.

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