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Hedge Funds vs Index Funds

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Whether you are brand new to the world of investing, or a seasoned expert, putting your money somewhere with the potential for growth without your involvement is an attractive prospect.

Both hedge funds and index funds are ways for people to invest in assets without having to build and actively manage their own portfolios. Despite this similarity, they are very different ways to invest, offering different advantages and disadvantages.

Hedge Funds

A hedge fund is an investment strategy where a pool of investors places their money in the care of a hedge fund manager, the manager then tries to create the highest possible profit with that money, for both the investor and themselves.

Hedge funds can invest in innumerable assets such as stocks, bonds, or real estate. The aim of the fund is to beat the market, giving maximum returns with minimal risk. Hedge funds use leverage to ensure that the risk is spread so that extreme or unexpected outcomes don’t lead to irretrievable losses.

As with any actively managed fund, often they fail to outperform the market average. In 2008 famed investor Warren Buffett issued a challenge to the hedge fund industry, declaring that over ten years, an S&P 500 index fund would outperform an actively managed hedge fund.

Hedge fund manager Ted Seides took the challenge and nominated a collection of funds to compete with Buffett’s index fund. After ten years the S&P 500 had gained an average of 7.1% annually (roughly 99% overall return), Seides’ funds had averaged just 2.2% annually (24% overall return).

Not all hedge funds boast such meager returns, however. The Quantum Fund, founded by George Soros and Jim Rogers grew an astonishing 4200% over a ten-year period.

The trick is, through careful research, to identify the funds that you believe will outperform the market, whether that is because of their alternative investment tactics, their pragmatic leadership or their concentration on a particular type of asset.

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Hedge funds can perform best in times of crisis, something that cannot be said for index funds. For example, the Bridgewater Pure Alpha II fund, managed by investing legend Ray Dalio climbed 9.4% in 2008, a time when the general markets were tumbling and the Dow Jones Industrial Average had fallen by 20% from it’s October 2007 all-time high. Having said this, it should be noted that performances like Bridgewater’s are very much the exception rather than the rule, and the majority of funds lost money in 2008.

Of course, since the fund manager is earning all this money for you, they will expect to compensate generously. Fees for hedge funds generally follow the 2 and 20 structure, where fund managers take 2% of the assets and 20% of the profits annually.

Sadly, hedge funds are generally reserved for those lucky individuals who have plenty of cash to spare already. For the majority of funds, the minimum investment is between $100,000 and $1,000,000. They are also only available to ‘accredited investors’, or in other words investors who:

  • Have a net worth over $1,000,000
  • Have annual income over $200,000 ($300,000 if married)
  • Are an executive involved in a hedge fund
  • Have a $5,000,000 trust fund

You don’t need to fit all the criteria, but you must fit at least one. Occasionally hedge funds are open to non-accredited investors, however, these spaces are often reserved for people with a personal connection to hedge fund managers, so they are very tricky to get hold of.

Ultimately, the majority of hedge funds are inaccessible to the average person, but if you think you fit the bill do check out our article on how to invest in hedge funds: How to invest in Hedge Funds. If not, then perhaps index funds are more suitable for you.

Index Funds

An index fund is a type of mutual fund that seeks to track an entire financial market. What you are essentially doing by investing in an index fund is you are buying a cross section of all the businesses in a particular sector, country or area.

As famed index investor Jack Bogle describes: “Don’t look for the needle, just buy the haystack!” For this reason, index funds are, in comparison to hedge funds, low risk. As you are buying a portion of all the companies in a certain index it doesn’t matter if one or two fail, because the rest will make up for those small losses and as a rule, over time, the market will always go up. The longer you leave an index fund, the less risk there is to tolerate.

Similar to hedge funds, there is a huge range of index funds to choose from. You could choose to invest in the S&P 500, which tracks the top 500 companies in America. There’s the FTSE 100, which includes the top 100 companies in the UK.

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There are index funds that track emerging markets, global markets, government bonds, technology markets, and cryptocurrency index funds that have recently started popping up. Choosing the correct fund is a case of choosing the level of risk you can tolerate, and then picking a fund that you think is likely to perform the best, whilst also considering the fees charged by the investment company offering the fund.

Index funds are often not given the credit they deserve as many investors kid themselves into believing that they can beat the market, despite the fact that the majority, including highly paid Wall Street professionals, fail to do so.

However, some of the world’s most successful investors recommend that the amateur investor simply pays into an index fund and leaves in alone. Warren Buffett recommends that investors simply invest in a low-cost S&P 500 fund, believing that the average ‘no-nothing’ investor will accumulate the highest gains this way.

This is very difficult to argue with, as the S&P 500 has grown an average of 9.8% annually over the last 90 years. The table below shows how $10,000 invested in the S&P 500 with a monthly deposit of just $300 would have performed:

Years Fund Value
10 $85,271
20 $276,982
30 $765,266
40 $2,008,907
50 $5,176,422
60 $13,243,982

 

The fees for index funds vary but are typically dramatically lower than any actively managed fund. The expense ratio for an index fund is almost always less than 1%, with some charging as little as 0.02% or $2 for every $10,000 invested. More typical rates are around 0.2%.

Unlike hedge funds, the bar for entry with index funds is remarkably low, so virtually anyone can invest in them. Typically, there will be a minimum investment, often between $3,000 and $10,000, however, if you have less spare change than this to work with, it is possible to find index funds that have no minimum deposit.

Finding a place to invest in an index fund is not difficult, there are a huge number of investment firms offering the chance for people to invest. You don’t even need to leave your house to do it, simply go online, fill in a few forms, deposit some of your hard-earned moolah and you’ll be an investor within a few minutes/hours (depending on how quickly you can type).

This is not to say that you should just go to the first firm you see, however; it is definitely worth it to shop around to find the best deals and the fund most suited to your needs.

Start your search with the biggest companies, such as Vanguard, Fidelity and Schwab, as these will give you a good baseline for comparison with smaller firms.

Check how much the fees are, look at the historical performance of the fund in comparison to the index (whilst remembering that past performance does not indicate future results), and read reviews of the fund and the company.

Also worth considering is what assets you should invest into, for long term growth stocks can be expected to outperform other assets, however, they bring higher volatility. On the other hand, if you are looking for stability then perhaps bonds are where you should be looking to invest. If you already have one type of asset, it could be a good idea to balance that with another type of asset.

If you’re looking for a bit of wild ride, then perhaps investing in a cryptocurrency index would interest you. The most important thing is to ensure that you do your own research and make sure you understand what you are investing in before you invest.

Choosing Which Investment is Right for You

Exactly which investment is right for you is a relatively straightforward question. For the overwhelming majority of people, investing in an index fund is likely to be the best investment decision that they ever make.

Index investing gives people who know very little about economics, the markets, or investing at all, the chance to compound annual returns of around 10% a year.

This is likely to beat any actively managed fund, individually curated portfolio, or most other asset classes in the long term. It is certain to beat any savings account (unless you know of a savings account that can make 10% a year, in which case please let me know).

The low fees and low risk of index funds mean that people can simply make their initial deposit, set up a recurring monthly deposit of what they can afford, and then forget about it.

As long as you are not forced to sell during a bear market, you will do just fine. Of course, one could improve their results by investing heaviest in a bear market, for example, had you invested $1,000 in the NASDAQ back in March 2020, just after the pandemic-induced stock market crash, you would have a cool $1,630 as of 19th August 2020, a 63% return over just under half a year.

The key thing to remember is to only invest what you can afford and ensure that you have a rainy-day fund set up that is made up entirely of cash.

If on the other hand, you are one of the lucky few who qualify to invest in a hedge fund, then they are certainly an option worth considerable thought.

Hedge funds are much more suitable to people who already have a reasonably good understanding of the markets and investment philosophies.

This is because hedge funds are attempting to beat the market, therefore there is great variance in how well they perform; some will multiply your money by hundreds whereas others will fail to post significant gains at all.

Finding a well-performing fund that looks likely to continue its upward trajectory into the future is the difficult bit, and as proven by Warren Buffett’s bet, often when you take into account fees, taxes, and fund performance, an index fund is the best option.

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It is also worth remembering that if you are looking to invest large sums, many investment companies cap fees for index fund accounts over a certain threshold.

For those who like the idea of actively managed funds but don’t meet the requirements for a hedge fund, then there are numerous actively managed mutual funds out there, many of which can be joined with very little starting capital.

It may be that you feel that neither of these options is the right option for you. You may feel that your money is best put into real estate, you may reckon you’re the next Peter Lynch and have plans for a portfolio of five or six stocks that will all turn into ten-baggers or perhaps you fancy a slightly more alternative investment, such as Brazilian street art or Russian agriculture.

Whichever style of investment you decide is for you, remember that research and independent thought is key to positive results, and more than anything to enjoy yourself.

Investing, if approached in the right way with the right mindset can be an enjoyable and extremely profitable side hustle or career, however, if it was easy to make big bucks in little time, then everyone would be doing it.

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