The main goal of investing is maximizing returns. With so many investment options available, it can be daunting to determine the best investment vehicle. Among the investment products available, hedge funds and mutual funds are the most common. Both funds provide investors with the benefit of diversification by allowing them access to a pool of investment funds. Both funds are also portfolios managed by a portfolio manager and aim to achieve high returns through diversification. Pooling of funds means that a fund manager or a group of managers use the investment capital obtained from multiple investors to invest in securities that align with a specific investment strategy.
Like mutual funds, hedge funds have a basic pooled structure. However, hedge funds are provided privately; therefore, they take higher risk positions to obtain higher returns for established investors. As such, hedge funds may use leverage, options, short-selling, and other alternative strategies.
Hedge funds are managed more aggressively than mutual funds. Many seek to achieve returns in failing markets or take global cyclical positions. Even if hedge funds are built around the same concepts of investing as mutual funds, they are structured and regulated differently. Given that they offer their investment privately, hedge funds only allow accredited investors to build their fund structures. Regulation D of the 1933 Securities Act outlines that only accredited investors can invest in private hedge funds.
Accredited investors have advanced knowledge of financial market investing. They also have a higher risk tolerance than average investors. High net worth individuals are willing to bypass the standard protections provided to mutual fund investors for an opportunity to potentially earn higher returns. Hedge funds employ a tiered partnership structure that includes a general partner and limited partners.
Due to their private nature, hedge funds have great flexibility in investor terms and investing options. Hedge fund fees are much higher than mutual fund fees. They also provide less liquidity because they have a lock-up period and redemption allowances. During volatile market periods, some funds may even close the redemptions to protect investors from a potential sell-off in the portfolio.
It is important to ensure that you understand the governing terms and the fund’s strategy risks before investing in hedge funds. The agreement terms for hedge funds are not publicized like mutual fund prospectus. Hedge funds rely on a private placement memorandum, an operating agreement or limited partnership, and subscription documents to govern their operations.
Mutual funds are popular in the investment industry. MFS Investment Management created and offered the first mutual fund in 1924. Since then, mutual funds have evolved to offer investors various choices in passive and actively managed investments.
With passive funds, investors invest in an index for targeted market exposure at a minimal cost. Active funds allow investors to access an investment product that provides the benefits of professional portfolio fund management. According to Investment Company Institute (ICI), a renowned research giant, there were 7945 mutual funds as of Dec 31, 2019. The mutual funds accounted for $21.3 trillion in Assets Under Management, abbreviated as AUM.
The Securities and Exchange Commission heavily regulates mutual funds under two regulatory directives. The Securities Act of 1933 calls for a documented prospectus for transparency and investor education. The Investment Company Act of 1940 provides a framework for mutual fund structuring. Mutual funds can be open-end or closed-end funds.
Both open-end and closed-end mutual funds trade daily on the financial market exchange. Open-end funds provide different share classes with varying fees and sales loads. The open-end funds’ price daily at their net asset value (NAV), usually at the end of trading.
Closed-end funds provide a fixed number of shares in an initial public offering, abbreviated as IPO. Like stocks, closed-end funds trade throughout the trading day. Unlike hedge funds, mutual funds are available to all types of investors, including average investors. However, some funds may have minimum investment requirements that could range between $250 and $3,000.
Mutual funds are managed based on specific strategies. The complexity of the strategies can vary, but most mutual funds do not rely on derivatives or alternative investing. Because they limit the use of high-risk investments, mutual funds are more suitable for the mass investing public.
Similarities Between Hedge Fund and Mutual Fund
The differences between hedge funds and mutual funds are more than the similarities. However, the two funds have a few things in common:In both funds, the investors hire professional managers to invest and manage their money Hedge fund and mutual fund managers select the securities to invest in and group them to create diversified investment portfolios for their clients Both funds work by pooling funds from a large number of investors and investing them with the help of a fund manager for a predetermined fee
Hedge Funds vs. Mutual Funds – The Differences
Most investors, especially those new to investing, group hedge funds and mutual funds under the same umbrella. At a glance, the two funds can seem similar, but they are completely different. The key difference between hedge funds vs. mutual funds is that hedge funds focus on the big fish – they focus on high-risk, high reward investments. On the other hand, a mutual fund sticks to the shallow waters where the returns are smaller but more reliable and less risky. Below are the main differences between the two funds:
Hedge funds are only available to sophisticated investors and high-net-worth investors (accredited investors). High net worth investors have a net worth of more than $1million, excluding their primary residence. They also have an annual income of more than $200,000 – the investor must have maintained this income for the last two years. The annual income level may vary from country to country. The minimum investment amount is higher for hedge funds than for mutual funds. Other hedge fund investors include large and sophisticated institutions with substantial investment experience. These institutions include foundations, pension schemes, university endowments, and insurance companies.
In the case of mutual funds, there is no restriction on investors – they are open to all investors, including retail investors. They also have a lower minimum investment threshold.
2. Investment Strategy
Investment strategies differ from fund to fund. Hedge funds employ more aggressive and high-risk investment strategies than mutual funds. The managers aim to generate profits for investors, regardless of whether the market is going up or down. To achieve this goal, they use high-risk tactics like taking speculative positions in derivative securities and short-selling stocks. Mutual funds do not take these highly leveraged positions. Therefore, a mutual fund is less risky, but there is a limit on its potential returns.
Mutual funds are limited, and a mutual fund manager can only invest in publicly traded securities like bonds and stocks. However, hedge fund managers are free to trade in anything they like, whether derivatives, stocks, real estate, public securities, Bitcoin, lottery tickets, or life insurance. The hedge fund industry is not highly regulated like the mutual fund industry.
4. The Holding Period
The holding period for hedge funds can vary greatly, depending on the fund strategy. The holding period could be microseconds, like with HFT firms, to years like with Global Macro. However, with a mutual fund, the investors’ money is locked away for several years.
Hedge funds charge both a management fee and a performance fee. The management fee is usually 2%, while the performance fee could range between 10% and 30% depending on the fund. Therefore, the better the fund performs, the higher the performance fee the investor pays. The “two and twenty” is the most common fee structure whereby an investor pays a 2% asset management fee and a 20% performance fee on the profits earned.
Many investors may be hesitant to accept this fee structure, given that the hedge fund managers earn the asset management fees regardless of how well the fund performs. The asset management fee could run into the millions. However, the managers mitigate this by having their own money in the fund. This aligns their interests with those of the hedge fund performing well. In recent years, the rising competition in hedge funds has caused compression of these fees. Therefore, only high-performing hedge funds charge the full “2 and 20” fee< structure.
Unlike hedge funds, mutual funds do not charge a performance fee. They only charge a management fee that ranges between 1% and 2%. Mutual fees are excessively regulated by the type and amount of fees they can charge. The management fee depends on the percentage of the money managed by the fund.
Mutual funds are heavily regulated on the period in which the earnings should be invested, the amount of capital that can be invested, and the overall investment strategy. However, no such regulations restrict hedge funds. The two funds operate under different legal and regulatory structures. Hedge funds are like a partnership between the investors and their hedge fund manager. Since they are not excessively regulated, managers have more latitude and can make riskier investments.
A mutual fund operates as a corporation, which the government heavily regulates under the Investment Company Act of 1940.
Mutual funds are heavily regulated, and the law requires them to provide investors with the ability to sell (liquidate) on a daily basis. This is not the case with hedge funds. Hedge funds are lightly regulated and have no liquidity constraints. Therefore, an investor may only exit their investment quarterly and, at times, after a longer period.
8. Long/Short Vs. Long-Only Investment
The long/short and the long-only are two distinct investment strategies. Typically, mutual funds employ the long-only approach, although there are some exceptions. Hedge funds also go short; thus, their name long/short funds. Hedge funds take the long/short approach to reduce the volatility of their portfolios. Hedge funds go long on undervalued stocks and go short on overvalued stocks.
Because mutual funds adopt the long-only approach, mutual fund investors are subject to the daily fluctuations of the market while hedge funds (long/short) experience much less fluctuation.
9. Management Style
While investing in both funds, investors do not select the securities to be included in their fund’s portfolio. Instead, a management team or a fund manager chooses the securities. Hedge funds are actively managed, meaning that the management team or the manager can use their discretion in security selection and timing of trades. However, mutual funds can be either passively or actively managed. If passively managed, the fund manager does not use discretion in security selection and timing of trades. Instead, the manager matches the holdings with a benchmark index.
Which is Right for You?
Mutual fund investments provide an investor with a minimum return rate known as the risk-free rate. Hedge funds focus on maximizing the investors’ return on investment. An average investor might not have the minimum investment or high net worth needed to invest in hedge funds. For retail investors, a wide portfolio of mutual or exchange-traded funds, abbreviated as ETFs, would be a better option than hedge funds. Mutual funds are also more accessible and cheaper than hedge funds. However, for high-net-worth individuals with a high-risk tolerance, a hedge fund would be an ideal option. Whether you should invest in hedge funds or mutual funds will depend on your financial capability and your risk tolerance.
The Bottom Line
Hedge funds and mutual funds are pooled investment vehicles structured in similar ways because they combine funds from investors under the management of a professional fund manager and invest in a wide range of securities. However, there are many differences in costs, investment goals, and who is allowed to invest beyond these similarities. Hedge funds offer higher returns but are riskier. Most people, especially retail investors, are better off investing in a mutual fund.