Hedge Funds vs Mutual Funds: Understanding the Difference
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Maximizing returns is one of the main goals of investing. But how do you know which investment vehicle to choose? You are probably familiar with mutual funds and may have heard of hedge funds. Read on to learn more about how these funds work, how they are different, and which one is best for you to maximize the return on your investments while minimizing your risk.
Overview of hedge funds and mutual funds
Hedge funds and mutual funds are two different types of investment funds. Hedge funds are generally private, riskier and only accredited investors are allowed to invest in them. Mutual funds are available for the public to invest and trade to achieve short, medium and long term goals.
Here’s a quick comparison of seven key differences between the two types of investment funds.
|Type||Hedge funds||Mutual fund|
|Who and how||A few established and accredited investors put money into an investment portfolio to purchase high risk assets.||Investors pool their savings into a compartment of market securities at generally affordable costs.|
|Contribution of funds||Significant personal financial investment||Low minimum; no mandatory minimum contribution|
|Types of investors||Companies and individuals with high net worth and high risk tolerance||Individual investors with limited disposable income|
|Types of regulations||Loose and limited regulation||Regulated stock exchange; more strict|
|Types of owners||Not a lot||Several thousands|
|Fund management style||Extremely aggressive||Less aggressive; aligned with investment objectives|
|Performance fees||Performance based||Based on managed assets; billed as a percentage|
The aim of hedge funds is to offer a few established investors a portfolio of investments to purchase assets, while mutual funds aim to provide investors with returns above the risk-free market rate of return.
Hedge funds explained
Hedge funds pool investor money and invest in securities or other types of stock market investments. Here are some characteristics of hedge funds:
- Use aggressive strategies
- Aim to maximize returns
- Are poorly regulated
- Have high risks and high fees
- Not intended for middle class investors
A look at mutual funds
Mutual funds are investment funds that pool the money of many investors to buy stocks, bonds, and other market securities. Investors include individuals, businesses and other organizations. Mutual funds are attractive to investors who:
- Favor a collective approach to investment
- You want to minimize the investment risk
- Difficult to own a basket of securities on your own
- You want low minimum investment requirements
Performance of hedge funds versus performance of mutual funds
The performance of hedge funds is based on assets under management. The performance of mutual funds is based on the number of investors required. Investing in hedge funds is riskier and generally generates higher returns; however, hedge funds have recently had less than stellar returns. Mutual fund returns are generally lower and involve less risk.
Investors and fund managers generally use five methods to measure fund performance:
- Alpha. A financial ratio that shows the returns a fund generates above the returns generated by the fund’s benchmark.
- Beta. Uses regression analysis and reflects the volatility of a portfolio relative to the market. You can see how your portfolio returns tend to fluctuate with the market.
- Expense ratio. The ratio of a fund’s total expenses to its assets. It reflects the unit cost of managing the fund.
- Fund portfolio allocations. Displays the diversification of a fund’s portfolio. The fund’s description sheet gives you details of your assets.
- Rolling returns. Average annual returns for a certain time looking at the fund’s assets until the last day of the period.
Similarities Between Hedge Funds and Mutual Funds
Hedge funds and mutual funds have more differences than similarities; However, here are a few things they have in common:
- Investors hire professional plan managers to invest their money in hedge funds and mutual funds.
- Hedge fund and mutual fund managers select and aggregate securities to create diversified investment portfolios for their clients.
Hedge funds charge a fixed management fee – typically 2% – and performance fees, which are typically between 10% and 30%. Mutual funds only charge a management fee, usually set between 1% and 2%.
Mutual fund fees are more heavily regulated than hedge fund fees. Investors in hedge funds can expect to pay more, the better the fund performs.
What should you know before investing in hedge funds vs. mutual funds?
The regulation of investments in hedge funds is stricter than that of mutual funds. Using a hedge fund is not as easy as withdrawing money from your bank account and depositing it on an online trading platform. Keep these things in mind before investing in hedge funds or mutual funds:
Before investing in hedge funds
- You must be a qualified investor.
- You need to know and understand your risk and your tolerance for risk.
- You need to know and understand how to determine fund values.
- You need to know and understand your fund management fees.
- Review and assess the qualifications of your future fund manager.
Before investing in mutual funds
- You need to understand the expenses and fees and how they apply to your future mutual fund.
- Check to see if your mutual fund is diversified.
- Review and assess the qualifications of your future fund manager.
Qualifications of accredited investors
If you choose to go the route of investing in hedge funds, be sure to meet the following criteria in accordance with Rule 501 of Regulation D of the Securities Act of 1933:
- You are an individual with more than $ 200,000 in income in the last two years or a joint income, if married, of more than $ 300,000 in the last two years. You should also expect at least the same income in the current year.
- You are a natural person whose individual net worth, or common equity if married, is greater than $ 1 million at the time of purchase of the hedge fund. This equity excludes the value of your primary residence.
Good to know
The money in mutual funds is held, that is, locked in, for several years. The holding period for investments in hedge funds varies and depends on the strategy of the fund. This period ranges from a few microseconds to several years.
Should you invest in hedge funds or mutual funds?
If you think you don’t qualify as a high net worth accredited investor, then investing in hedge funds may not be for you. Consider investing in mutual funds instead.
If you qualify as a high net worth accredited investor, read stock performance charts to see how hedge funds perform in a bear market relative to mutual funds. Both types of funds are sensitive to market downturns and have fees that can weigh on returns. Consult with a fund manager to help you make the right decision for your investment goals.
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