Hedge funds and mutual funds are sometimes used interchangeably. However, they have some important differences, which will be explained in this article.
Both hedge funds and mutual funds are managed by investment professionals, are open to both accredited and non-accredited investors, and their returns depend on the investment manager’s skill (s).
This article will discuss the differences between mutual funds and hedge funds, how they are similar, the risk involved in each type of investment, and how to decide which one to include in your investment journey.
What is a Hedge Fund?
Simply put, hedge funds are places where rich people can park their money. BlackRock, Bridgewater Associates, and Elliott Management owns some of the most popular hedge funds. All three are established investment companies that run their internal hedge fund.
Hedge funds operate on the same pooling of funds concept as mutual funds; however, they are much more exclusive and offered privately to high net-worth individuals.
In a nutshell, hedge funds are private, lesser-regulated investment pools that allow wealthy investors to make big bets on the stock market. They use the strategies and techniques of trading to make a profit. Institutional investors mainly use them like wealthy individuals, corporations, pension funds, and endowments. The risks involved in these investments are high, but so are the rewards.
Most hedge funds are not bound by the strict rules imposed on mutual funds, so they can do more adventurous things with their money than mutual funds can. For example, the Securities and Exchange Commission doesn’t regulate hedge funds as strictly as it believes qualified investors for the fund are knowledgeable and conscious enough of the potential risks.
Tailor-made portfolios are another characteristic of hedge funds. Managers choose their investments, making decisions about buying or selling stocks, bonds, commodities, or other assets based on their analysis of market conditions.
What is a Mutual Fund?
Mutual funds pool money from many investors and invest in stocks, bonds, short-term papers, or other securities. The investors own shares in the fund. So if you buy a share of the fund, you have a tiny piece of all the investments owned by that fund.
Since mutual funds can buy more securities than most people can afford to buy on their own, they can invest in risky but potentially very profitable industries or parts of the world. They also let you diversify your risks: it won’t wipe out your whole investment if one company goes bankrupt. And they usually charge lower fees than most people could negotiate by themselves.
But there are some risks. For one thing, your returns may be lower than with individual investments; that is because their expenses (buying and selling securities) take a bite out of your profits. Moreover, if the fund manager doesn’t know what they are doing, your returns will be even worse than that.
The organization that establishes and maintains a mutual fund is called an investment or fund company. It may be an independent company or owned by a large financial institution such as a bank or insurance company.
The Vanguard Group is one of the largest mutual fund companies with over $1 trillion in assets under management. The group offers more than 100 different mutual funds.
How are Hedge Funds and Mutual Funds similar?
Hedge funds and mutual funds share some fundamental similarities.
Both operate on the pooling of funds
Both hedge funds and mutual funds are pools of investor money. In a mutual fund, the investors buy shares representing fractions of the fund’s holdings. In a hedge fund, they buy stakes in the fund itself. The basic idea is similar in both cases: investors pay to have their money managed by professionals who invest it in financial markets.
Both aim for diversification
The similarity between a hedge fund and a mutual fund is that both are investment vehicles that hold stocks and bonds that attempt to produce high returns for their investors. Mutual funds are more traditional, but hedge funds are newer and riskier.
Both aim for long term profitability
Both hedge funds and mutual funds are designed to provide investors with a steady income, as well as the potential for long-term growth. The two are also used to help investors avoid risk in their investment portfolios. They both have the potential to increase their returns on investment, but they should also protect them from the risk of loss.
How are Hedge Funds and Mutual Funds Different?
Despite their conceptual similarities, mutual funds and hedge funds have key differences in how they operate.
Similar goals, different outcomes
Mutual and hedge funds can be distinguished by their goals. Mutual funds aim to make money for their investors through reinvestment and capital appreciation, while hedge fund strategies seek to profit from short-term price movements regardless of market conditions.
The latter’s goal is to profit through short-term price fluctuations, whether the market goes up or down. These funds employ more complex investment strategies than mutual funds and have historically been able to charge higher fees because of their ability to generate higher returns.
Investment requirements differ
The types of investors you’ll see in both vehicles differ greatly.
Hedge funds are a lot more exclusive and have minimum investments by way of who is eligible to invest in the fund. To invest in hedge funds as an individual investor, you must be in the category of an institutional investor, otherwise also referred to as an accredited investor. This means having a net worth of at least $1 million.
The investment funds in mutual funds, on the other hand, are a lot more accessible. You don’t have to be a rich retail investor or have a huge amount of money in the bank to back you up. Mutual funds are open to common individuals.
Different regulatory bodies
Hedge funds are a kind of fund that is not as regulated as mutual funds. They are also known as private investment companies (PICs).
Hedge funds typically have fewer rules and regulations than mutual funds, allowing them to invest in more aggressive investments, such as derivatives and short selling. Mutual funds may be purchased on the open market, but hedge funds are sold privately and must meet certain investment criteria.
The two types of funds have different regulatory bodies. Mutual funds are regulated by the U.S. Securities and Exchange Commission (SEC), and hedge funds fall under the jurisdiction of the Commodity Futures Trading Commission (CFTC) for futures contracts and National Futures Association (NFA) for options. The SEC also regulates some hedge fund activities such as prime brokerage services.
Overall, hedge fund investors have much less regulation than mutual funds and thus pose more flexibility.
Scope of investments
A hedge fund is a kind of investment pool that can invest in anything. It is not limited to just one stock or bond. Rather, it can purchase stocks, bonds, commodities, currencies, and other financial instruments. This allows the fund to generate higher returns than a normal mutual fund.
A mutual fund is also a kind of investment pool. However, its mandate is to provide investors with a certain level of return based on how much money they put in. Therefore, it can only invest in stocks or bonds provided by companies within its target industry (for example, all utilities). Mutual funds provide less control over the investment portfolio but are less risky than hedge funds.
Risk exposure
Hedge funds can be risky because many have little or no regulation, do not limit how much they can lose and are not required to disclose information about their holdings or strategies. Some funds also use novel trading techniques like “short selling,” which involves borrowing shares of a company’s stock, selling them, and then buying them back later at what is hopefully a lower price to make money from the difference.
Mutual fund managers generally select from a pool of potential investment candidates based on their analysis of each security’s intrinsic value; how that value compares with the current market price determines whether it is a buy or a sell candidate for the fund. Investors can redeem their holdings in mutual funds at any time, although there may be penalties for doing so before a specified period has passed.
Mutual funds are considered more stable than hedge funds because they have more assets, making them less vulnerable to sudden drops in value.
Different investment strategies
Hedge funds and mutual funds are similar in the type of investments they make. Both hedge funds and mutual funds invest in stocks, bonds, and other assets. However, hedge funds use a more aggressive investment strategy than mutual funds.
Hedge funds can be both long and short. This means they can buy assets (long) or sell assets (short). Mutual funds are only long. Mutual funds invest in stocks and bonds, while hedge funds may also invest in private equity, foreign currencies, and commodities.
Fee structure
A hedge fund is a private investment partnership. It charges high fees and allows the hedge fund manager to invest as he sees fit.
Managers of a mutual fund are restricted by the terms of their organization to the investments in their prospectus. The prospectus contains their track record, composition, management fee, cost ratio, and other factors.
Hedge funds can charge high fees because they aim for higher returns than mutual funds.
Hedge funds charge management and performance fees, so you pay more the better the fund performance. The most common fee structure is ‘two and twenty’: a 2% asset management fee plus a 20% cut of any profits returned.
On the other hand, mutual funds charge only a management fee as far as professional expenses are concerned, usually around 1–2%. Other fees are linked to the expense ratio, but they are all heavily regulated around the amount and way they are charged.
However, as they have less volatility and risk, they also offer fewer returns.
Hedge Funds vs. Mutual Funds: What’s right for you
Virtually every investor should have some exposure to the stock market, and the two most common investment vehicles for small investors are mutual funds and hedge funds. Both investments open up a world of opportunities for investors, but as you can see, there are some major differences between them.
However, hidden fees can eat into your returns, with some funds taking big chunks for performance-related fees, administrative fees, distribution fees, and more.
So how do you pick between the two? Consider your investing goals, risk tolerance, and whether you’re willing to pay for expertise. Both types of funds offer good options for most investors.
Investors should carefully consider how much risk they can afford to take before deciding which vehicle is right for them.
When you should consider a hedge fund
The more comfortable you are with uncertainty, the more likely you will be happy with a hedge fund over a mutual fund. This is because mutual funds tend to be more conservative than hedge funds, so they will tend to have lower returns (and thus lower expected risk) over time than similarly managed hedge funds will have.
Hedge funds are an alternative for investors who want to increase their returns by investing in a more volatile asset class. However, they are not for everyone: as with all investments, you must understand your own financial needs and limitations before making any investment decisions.
Remember that when you buy into a hedge fund, you’re not buying shares; instead, you’re entering into a contract that binds both parties to certain terms and conditions.
Keep in mind that hedge funds target high net-worth individuals. If that sounds like you, you should certainly consider it!
When you should consider a mutual fund
If you are a small investor, one who’s managing less than $25,000, and who prefers to take a conservative approach rather than invest individual stocks or bonds, then you’re probably best off with a mutual fund. Because of the way mutual funds are regulated, they’re required to act in the best interest of the shareholders.
It’s worth remembering that even an undiversified mutual fund is more diversified than any single stock or bond you could buy on your own. Mutual funds give you exposure to hundreds or even thousands of companies; individual stocks give you exposure only to one company. Mutual fund investors also unlock more liquidity, especially in closed-end funds that trade.
Mutual funds may not be right for you if you want to invest in only one area or if you want to invest in an exotic investment like a startup company.
Trying to beat the market instead of matching it may well leave you worse off. However, you can give it a shot if you’re a more experienced investor.
FAQs
Are hedge funds riskier than mutual funds?
Yes. Hedge funds are relatively unregulated and subject to more market risk due to the high-risk investments they make.
What can hedge funds do that mutual funds cannot?
Hedge funds offer more flexibility in terms of investment vehicles. It can generate higher returns as a result but is prone to more losses.
Do hedge funds invest in mutual funds?
Its mandates dictate a hedge fund’s investments limits. It can invest in anything from derivatives, real estate, bear markets, and more, including mutual fund portfolios.