If you know even a teensy bit about hedge funds vs. mutual funds, you’ll likely know this for sure: hedge funds are unregistered private investments that require investors, including institutional investors, to have plenty of money at their disposal.
On the flip side, mutual fund managers invest your money in stocks, bonds, and short-term debt. Mutual funds are usually on the affordable side and could be a great option if you prefer a fund manager to manage your money for you.
What are hedge funds?
Hedge funds pool money from investors and invest in securities or other types of investments. They’ve invested aggressively with the goal of maximizing returns and are not as heavily regulated as mutual funds. They’re riskier, and the fees are high, which would likely prohibit middle-class investors from parking their money in a hedge fund.
What should I know or do before investing in hedge funds?
Compared to many other investment types, hedge fund investing is more stringent. It’s not as easy as hopping onto TDAmeritrade. and popping in $2,000 from your bank account. In fact:
- You must be an accredited investor. Rule 501 of Regulation D of the Securities Act of 1933 states that an accredited investor is:
• “A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.”
• “A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person.”
- You should understand risk. You’ve likely heard, “Higher risk means higher returns.” That’s exactly the mindset and strategy that hedge fund managers swear by. The way they invest your money means you could lose more than you gain. Hedge fund managers often invest in traditional securities but also branch out derivatives (futures and options) which often involve leverage, which is always a risky proposition. They also try to time the market, which experts have agreed that is nearly impossible to do.
- You should understand how fund values are determined. Often, hedge funds are difficult to value, as in it can be tough to determine the intrinsic value of certain funds. Know how the hedge fund manager determines the value of the funds used.
- Be sure you understand the fees exacted by the fund manager. A lot of hedge fund managers charge a performance fee (the industry standard is 20%) of the hedge fund’s profit as well as a management fee of assets in the fund, about 1-2% annually. If the fund loses money for a few years, the fund manager can’t collect performance fees, and must attain its high-water mark (the highest peak in value that an investment fund or account has reached) before collecting a performance fee. Read your prospective fund’s prospectus and any other materials you can get your hands on.
- It’s wise to review a hedge fund manager’s qualifications. According to investor.gov, you can check out the advisor’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. If you can’t find the investment advisor firm in the SEC’s IAPD database, you can call your state securities regulator or search FINRA’s BrokerCheck database.
What are mutual funds?
Mutual funds are investment funds that pool money from many investors (including individuals, companies and other organizations) to purchase stocks, bonds, and other securities. This collective approach is beneficial because a basket of securities (otherwise known as a portfolio) might be tough, if not downright impossible, to recreate on your own.
What should I know or do before investing in mutual funds?
As with anything you’re investing, there’s a pro list and a con list. It’s true with mutual funds, too, but there are a few other items you should be checking specifically with these types of investments.
- Understand loads and expenses and how those apply to the mutual fund you’re considering.
• Front load: These fees are charged at the time of purchase and can be 5% or more of the amount you’ve invested.
• Back load: These fees are charged on the back end, as the name indicates, or in other words, when you sell a fund.
• No load: These types of mutual funds offer no front or back load; the load fees are waived.
• Expense ratios: While you may or may not be considering a loaded mutual fund, mutual funds do charge expense ratios or have an operational charge. Charges and expenses will vary, depending on which mutual fund you’re considering.
- Is it diversified? Check to see how the mutual fund you’re considering is diversified. Does it offer a combination of stocks and bonds? Typically, most do, as that’s the point of a mutual fund. It might cover a huge bundle of stocks and a few bond funds thrown in for balance. Know what those companies are before you take the plunge; read the prospectus and any other materials you can get your hands on.
- Check out your prospective advisor. Look for your mutual fund advisor in the SEC’s IAPD database, or you can call your state securities regulator or search FINRA’s BrokerCheck database.
Similarities between hedge funds and mutual funds
Hedge funds and mutual funds have a few similarities:
- Professional money managers are paid to invest for their clients.
- Managers choose and bundle securities, which creates a diversified portfolio of investments.
Differences between hedge funds and mutual funds
The similarities end pretty quickly, as there are some sizeable differences between the two fund types. There are more differences, however, the largest three differences are:
- Hedge funds are regulated much more loosely than mutual funds; they’re not actually regulated by the SEC, unlike mutual funds.
- Hedge funds are managed more aggressively; therefore, mutual funds are considered a “safer” investment.
- Hedge funds are only available to high net worth or accredited individuals.
This question might still remain: Why invest in either? What’s in it for me? It’s obvious that investors are attracted to hedge funds or mutual funds for very different reasons. Your inability to qualify as an accredited investor may preclude you from hedge fund investing, so mutual funds or other investment options may be your only avenues.
Look at any performance chart, and you could argue that given hedge funds’ goals of absolute returns, they really don’t perform in a bear market in particular. Mutual funds are not immune to downturns either, of course, and in both cases, fees can eat away at overall returns in the end.
Therefore, what’s best? Ultimately, if you know for a fact you’re not interested in managing your money on your own, then it’s imperative to do your research to be sure you’re getting the best fund manager and fund selections that you can.