Hedge funds and mutual funds can seem intimidating. Both generate returns through diversifying pooled funds from a large pool of investors. However, mutual funds provide a range of redemption options for everyday investors while hedge funds are more restricted.
Both can generate returns for their investors, but each operates under a different set of regulations.
Mutual funds are more accessible than hedge funds, which offer less liquidity to investors. Hedge funds require investors to meet specific accreditation characteristics. This article illustrates their similarities and differences.
What Is a Hedge Fund?
A hedge fund is an alternative investment that pools capital from individual or institutional investors to invest in a range of assets. It relies on complex techniques to build its portfolio and manage risk. It is a type of actively managed fund that focuses on high-risk, high-return investments and invests aggressively using leverage to increase returns. Hedge funds can invest in anything from real estate and commodities to currencies and other alternative assets.
Hedge funds have the same basic pooled fund structure as mutual funds but are only offered privately. Typically, these funds take higher-risk positions to generate higher returns. They also use a range of investment strategies such as options, leverage, short-selling and other alternative strategies. Overall, hedge funds employ highly risky investment strategies and are usually managed much more aggressively than their mutual fund counterparts. Many seek to take globally cyclical positions to achieve returns in markets that are falling.
Hedge funds offer private investments and build their funds only from accredited investors. Regulation D of the Securities Act of 1933 mandates investments from accredited investors in private hedge funds. Accredited investors have advanced knowledge of investing in financial markets and a high tolerance for risk.
These investors are willing to bypass standard protections offered to nonaccredited investors for the opportunity to potentially earn higher returns. As private funds, hedge funds also differ in that they usually operate on a tiered partnership structure, which is made up of general partners and limited partners.
What Is a Mutual Fund?
A mutual fund is a trust that collects money from many investors who share a common investment goal for their funds. It is, essentially, money that is pooled by a large number of people or investors and is managed by a professional fund manager. The professional portfolio manager invests the money in equities, bonds, money market instruments or other securities to generate a return.
Each investor in a mutual fund owns units that represent a portion of the total holdings of the fund. The total income or gains generated from the collective investment is shared proportionately among investors once certain expenses are deducted. A mutual fund targets a larger number of people and cannot invest in risky or illiquid assets such as derivatives.
How Are Hedge Funds and Mutual Funds Similar?
Both mutual funds and hedge funds are managed portfolios built from pooled funds to achieve returns through diversification. Mutual funds are offered by institutional fund managers with several options for retail and institutional investors. Hedge funds target high-net-worth investors.
Both hedge funds and active mutual funds are investment products that are managed professionally by a fund manager. Hedge funds and mutual funds can invest in stocks and bonds, and both investment vehicles charge investors a fee for the services they provide.
How Are Hedge Funds and Mutual Funds Different?
Hedge funds and mutual funds derive from the same concepts. Their structure and regulations differ.
Investment Strategy
Hedge funds are known for taking higher-risk positions with the goal of higher returns for the investor. As such, they use options, leverage, short-selling and other alternative strategies. Meanwhile, mutual funds are managed to trade securities based on a specific strategy.
Type of Investor
By limiting the use of high-risk investments, mutual funds are better suited for the mass-investing public. Conversely, hedge funds are reserved for individuals who have a high tolerance for risky investments and expect far greater returns than general market performance.
The private nature of hedge funds allows them a great deal of flexibility in their investing provisions and investor terms. Mutual funds are available to the general public, while hedge funds target high-net-worth individuals who invest between $100,000 and $2 million on average. Mutual fund investors prefer the flexibility of being able to convert their assets into cash, while hedge fund investors are likely to withdraw at specific periods of the year.
Fees
Hedge funds charge much higher fees than mutual funds. Mutual funds charge a management fee of 0.5% to 1% of the total investments managed by the fund. Hedge funds have complex fee strategies. Customarily, a hedge fund might charge a 2% annual management fee and a 20% cut of the profit, which is called carried interest. Some of the best funds charge even more with carried interest rates of 30% or higher. In recent years, competition among profitable hedge funds has caused fees to fall. Only top-performing funds still receive the full 2-and-20 fee structure.
Liquidity and Redemptions
The redemption terms of hedge funds and mutual funds are different. Hedge funds are less liquid and offer less liquidity with varying lock-up periods and redemption allowances. Some funds may close client redemptions during periods of market volatility to prevent huge selloffs in the fund’s portfolio. On the other hand, profitable mutual funds accommodate redemptions by selling some of their risky asset holdings to specialized liquidity providers such as hedge funds.
You can redeem your funds in a mutual fund at any time and receive the net asset value of the trading day when you redeem your investments. However, hedge funds are more strict and tend to offer quarterly or annual redemptions.
Differences between hedge funds and mutual funds include:
- Mutual funds don’t take shares from the profit while hedge funds take 20% of the returns on average.
- Mutual funds are available to the general public while hedge funds are available only to high-net-worth clients.
- Hedge funds tend to perform better than mutual funds.
- Hedge funds make high-risk investments while mutual funds make lower-risk investments.
- Profitable hedge funds charge a 2% management fee plus a 10% to 30% performance fee while mutual funds charge a management fee of 1% to 2%.
- Mutual funds are more liquid than hedge funds.
Best Brokers for Investing
The table below provides an overview of the best mutual fund brokers.
Pooled Investments Can Be an Important Portfolio Addition
Hedge funds and mutual funds pool capital from investors to make investments. They differ in risk tolerance, management fees and liquidity. It is important to read the hedge fund or mutual fund’s prospectus to understand your redemption rights. For more information on hedge funds, mutual funds and other types of investments, come back to Benzinga for more information or subscribe to the newsletter.
Frequently Asked Questions
Are hedge funds the same as mutual funds?
Hedge funds and mutual funds operate differently but both pool capital from a large number of investors. Mutual funds are regulated investment products offered to the public and available for daily trading. Hedge funds are private investments that are only available to high-net-worth accredited investors and use higher-risk investment strategies to generate higher returns.
Can a mutual fund invest in a hedge fund?
A mutual fund cannot invest in a hedge fund as they are regulated differently and offer different forms of liquidity to their investors. Hedge funds seek higher returns using speculative positions and trade in derivatives and options while mutual funds are restricted to equities and bonds.
Should you invest in a fund?
Investing in a fund depends on individual financial goals, risk tolerance and investment strategy. It can offer diversification, professional management, and potentially higher returns. Thorough research, understanding the fund’s strategy and fees and consulting with a financial adviser are important before making any investment decisions.