Hedge Funds vs Mutual Funds

A visual representation of the ever-changing trends of the stock market.

You may be looking at different types of investments and wondering which strategies are right for you. Hedge funds and mutual funds are two strategies that are commonly discussed, and there are debates in the financial world over which is better.

Hedge funds and mutual funds both have risks and benefits and have distinctly different goals. When discussing hedge funds and mutual funds, things can get confusing because there are similarities between the two types of investment methods. However, there are also differences that may make hedge funds out of reach for some, and make mutual funds seem less appealing.

Your financial goals, as well as your income, play a large part in which investment style is the right one for you. Researching each, and doing your due diligence by gathering as much information as possible about mutual funds vs hedge funds will help you make an educated decision if you have decided the time is right to try to expand your portfolio.

We have compared mutual funds and hedge funds to help you understand the difference if you are new to investing and are trying to familiarize yourself with the different types of investments you can make. Keep reading to learn more about mutual funds and hedge funds, and their similarities and differences.

What Are Mutual Funds?

A mutual fund is made up of the pooled investments of a group of investors. It is given to a manager who invests the funds on behalf of the investors. The money is invested in stocks, bonds, and money market accounts. Mutual funds aren’t just an investment. They are also generally part of a larger investment company, which may be made up of hundreds of different mutual funds. When you invest in mutual funds, you are purchasing part of the company and the assets it generates through its investments.

A board of directors in charge of hiring the fund managers. The managers are obligated by law to work for the best interests of the shareholders and the funds. Since mutual fund managers are generally also owners of the fund, this is also in their best interest.

There may be a small team of analysts involved to study the market, and help decide which investments should be made. There are also compliance officers involved, as well as an attorney, to make sure the mutual fund is operating according to government guidelines.

Investors are affected by the fluctuations in the fund, based on their contribution. Mutual funds earn money in 3 different ways.

  • Through stock dividends, and bond interest. Investors can either choose to take a payout at the end of the year or reinvest their earnings.
  • Through capital gains made through stocks that have been sold.
  • If the fund holdings increase and you sell your shares.

There are several types of mutual funds, each designed to suit the approach of their investor pool.

  • Equity funds- The main investment category for this type of fund stocks. Some invest in domestic funds, and others range further afield and invest in foreign stocks. There are many subcategories within the equity funds, determined by the type of stocks they invest in.
  • Fixed income funds- These are mainly focused on generating income. Their investments are typically government bonds or other vehicles that generate interest.
  • Index funds- With this type of mutual fund, the manager focuses on buying Major market index stocks. It requires less work than other types of mutual funds and generates fewer expenses.
  • Balanced funds- These are a mix of different investment types. This strategy is used to mitigate risk, by allocating funds across a variety of investment types.
  • Money Market Funds- These are used as low-risk places to “park” your money. The returns are lower, and they are generally used by people who want to invest without risking their assets.
  • Income Funds- These are designed to help generate steady income.
  • International/Global Funds- These are investments that are made exclusively outside your home country.
  • Specialty Funds- These funds utilize a more focused strategy by focusing on a specific economic sector.
  • Socially Responsible Funds- These use personal ethics to determine which companies and stocks they invest in.

Along with the types of mutual funds, they are also divided into classes.

  • There are A-shares that are purchased through a broker. There are front end load fees of 5% or more. Which means the fees are paid when the investor buys into the fund. In addition to the load fees, there are ongoing fees including management and distribution fees. These are called 12b-1 fees.
  • B-shares do not charge fees until after investors sell their shares.
  • C-shares, also known as level load shares, charge a 1% annual distribution fee. This fee is a 12b-1 fee.
  • Clean-shares are newly developed types of shares that do not require a loading fee or any 12b-1 fees. Clean shares are more transparent, and save investors money over time.

Mutual fund companies you may be familiar with include The Vanguard Group, T Rowe and Price, Oppenheimer, and Fidelity Investments. You may have money invested in a mutual fund and not be aware of it. Most retirement plans offered by employers put the money in mutual funds.

You can find more about mutual funds in Investopedia.

What Are Hedge Funds?

Also made up of a pool of investors and a manager who determines the avenues of investments, hedge funds take a riskier approach to investment. Hedge funds invest in stocks and bonds, as well as real estate, art, and other less conventional avenues. Like mutual funds, hedge funds are categorized based on the investment strategies that are utilized. Most hedge-funds are designed to make money despite market conditions, which is why many investors who have previously invested in hedge funds, have stated they would do so again.

To invest in a hedge fund you must be what is known as an “accredited” investor. This means you must have made over $200k annually for the past 2 years, have a net worth of $1 million, or a trust fund worth over $5 million. The buy-in for the majority of hedge funds is between $100k and $1 million.

There are numerous types of hedge funds, named based on the investment strategy that is used. A few you may encounter while searching for investment opportunities include these:

  • Convertible Arbitrage- This strategy takes advantage of inefficient pricing by buying convertible securities in a company while short-selling their common stock. This is a lower-risk strategy.
  • Distressed Securities- In this strategy stocks and bonds are purchased from companies that are facing bankruptcy. These securities are being sold at rock bottom prices, and are being purchased with the expectation that they may increase in value. This strategy is riskier since it can not be guaranteed that these distressed securities will actually rebound.
  • Emerging Markets- This strategy takes a risk by investing in countries with the companies that are beginning to emerge as financial players. The securities from these developing countries can be purchased at lower prices than those from more developed areas. The risk factor with this strategy is high since developing nations experience higher rates of inflation and growth is occurring more quickly, but there is also a major risk of their market becoming destabilized.
  • Event-Driven Investing- This strategy takes advantage of unexpected events that may lead to price inefficiencies. This is considered a moderate risk.
  • Long/Short Equity- This allows flexibility because some securities are being helped long, while others are short. Stock is purchased from companies that are expected to perform well, while prices are still lower, while the stock of companies that are anticipated to underperform is sold short.

Other hedge fund types are Macro, Long Equity, Short Equity, Market Neutral, Merger Arbitrage, Fund Of Hedge Funds.

There are hedge funds for those who make conservative investments and those who are willing to take more of a risk.

You can read more about hedge funds here.

What Makes Them Similar?

A couple of colleagues discussing hedge funds and mutual funds.

Mutual funds and hedge funds seem very similar on the surface.

  • Investor pools- Both hedge funds and mutual funds are made up of the pooled assets of multiple investors.
  • Professional management- In both hedge funds and mutual funds, the investors have no control over the investments. They are handled by a manager or management team that makes decisions regarding the selection of securities and the allocation of assets.
  • Diversification- Hedge funds and mutual funds both make multiple investments to maximize returns, though with mutual funds it tends to be more targeted than with hedge funds with the focus on what type of security or sector.

What Are The Differences?

Then you look at them in detail, differences between mutual funds and hedge funds are more numerous than the similarities. From who is allowed to buy in, to the fee structure, and the way money is invested, hedge funds and mutual funds are two distinctly different investment vehicles.

  • Who can invest – Mutual funds are far more accessible to the average person looking to add to their portfolio than a hedge fund. Hedge funds require investors to meet certain income guidelines and have extremely high buy-ins. Mutual funds have much lower buy-in amounts, as low as $100, and do not have any restrictions based on net worth
  • What they invest in- While mutual funds are generally limited to stocks and bonds, hedge funds are able to invest in non-traditional avenues such as land and art.
  • Fees- Hedge fund fees are generally based on the 2-20 model, with managers being entitled to 2% of the assets as well as 20% of the profits annually. Mutual funds have fees of 1% -3% or lower, and sales fees are determined either prior to investing, or after an investor sells their shares.
  • Performance- Hedge funds are designed to take advantage of all market conditions, which can produce a return even during a bear market. Mutual funds will however generally have higher returns in a bull market, although they will be more adversely affected during an economic downturn.
  • Lock-in period- Hedge funds require an initial lock-in period of at least a year, with additional lock-in periods. With a few exceptions, mutual funds are more fluid, with no lock-in periods. The ELSS is one of the exceptions to the lock-in period, this type of mutual fund has a lock-in period of 3 years.
  • Regulations- Because hedge-funds are limited to “accredited” high-income investors, they are regulated much more loosely than other investment vehicles.

Advantages Of Mutual Funds

This is an illustrative representation of Mutual Funds.

Mutual funds and hedge funds are targeted toward very different types of investors.

Mutual funds are accessible to the average person and are good for those who want to diversify their portfolio, but who may not have a large amount of capital.

Those who are attempting to save for retirement, who are attempting to earn some extra income from the interest on their investment or those who want to invest but do not have the ability or the knowledge to know where to put their money may be interested in mutual funds. For the beginning investor, mutual funds are a low-risk way to get your feet wet.

Mutual funds generally allow you to easily withdraw your money. If you require your assets to be fairly liquid, then a mutual fund may be worth consideration.

Mutual funds are easy to find, and there are numerous online tools that make them accessible. Often online brokers do not charge fees.

Disadvantages Of Mutual Funds

Mutual funds come with a number of advantages. To make a truly informed decision, however, you need to be aware of the disadvantages. Like every investment too, mutual funds also come with drawbacks.

While mutual funds may be lower risk than some other investment strategies, they do not come with no risk. Since mutual funds rely on market performance there is no guarantee of returns.

Mutual funds can be conservative in their investments, so if you are looking for large and quick returns, you may not see them, although over time mutual funds can generate a decent profit.

Some mutual funds may charge excessive amounts of fees. The associated fees may be too high to make the investment worthwhile. The fee structure should be vetted before making a decision to place your money with any fund.

Advantages Of Hedge Funds

A visual representation of managing a hedge fund.

Hedge funds have a number of advantages. They provide diverse strategies to attain the goals of investors. For those who are looking for sky-high returns, some of the riskier strategies may seem worthwhile. The more conservative investor can still anticipate a decent return on their investment with the lower risk strategies.

They offer a chance to diversify your portfolio while maintaining balance through high and low markets. Hedge funds are able to do this by “hedging” the market. This means they offset their risk by strategic planning.

Hedge fund managers are typically highly skilled and experienced. This means they are able to make well-informed decisions regarding investment styles.

Disadvantages Of Hedge Funds

Hedge funds are not within reach of the average person. The income requirements, combined with the extremely high initial investments they require, make them available almost exclusively to the wealthy.

Hedge funds are by nature higher-risk than mutual funds. The moves made by the managers are more aggressive, which is why they require a higher initial investment.

Though the risks are somewhat mitigated by the diverse spread of investments, the higher risk strategies and use of leverage can lead to devastating losses.

The investments made in hedge funds are not fluid, and the money can be difficult to access. The lock-in period can last several years, and the money can only be accessed at certain times.

The 2 and 20 fee structure can end up taking quite a bit of money out of the pockets of the investors.

The lack of regulation around hedge funds makes them more susceptible to fraud. This can take on the form of misleading statements, misinformation about the state of the hedge fund, and embezzlement of funds.

Hedge Funds vs Mutual Funds

So which is better, hedge funds or mutual funds? The answer is, it depends. The investment strategy that is right for you depends on a number of factors. Your financial goals, your income and your tolerance for financial risk all come into play.

If you have the funds to qualify to invest in a hedge fund, then you may want to give hedge funds a second look. They have the potential for huge returns and with the right strategy, the risks are minimal.

If you are like the majority of people and a hedge fund is out of reach for you, then mutual funds may be the way you want to go. There are no barriers to entry, you will be able to access your money, they are low risk and require little work on the part of the investor.

The only way to truly decide if either of these strategies is right for you is to discuss your options with a financial planner. They can help you clarify your goals, and decide on a strategy that you are comfortable with.

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Why Are Legal Documents on Long Paper?

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Hedge Funds vs Index Funds