How are they different?
In short:
When looking at different investment products out there it’s not uncommon to hear about mutual funds and hedge funds. What’s the difference though and which one is better?
On the surface, mutual funds and hedge funds have many similarities. Both are pooled investment vehicles that use money managers. The main difference is who each one is open to and the investments they make. Hedge funds are only open to high net worth individuals called accredited investors. Mutual funds on the other hand are open to all individual investors.
Additionally, hedge funds have more flexibility in the investments they make than mutual funds do. This is due to their structure which will cover in a bit. Knowing the differences can help you decide which one is right for you.
Key Differences
| Hedge Funds | Mutual Funds |
|---|---|
| Private – Accredited investors only | Public – Open to all investors |
| Limited regulations | Highly regulated |
| High fees – “2% and 20% of profit” | Low fees – typically 1% or less |
| Actively managed | Actively or passively managed |
| More aggressive strategies | Less aggressive strategies |
| Open to taking higher risk investments | Limited on higher risk investments |
| Possibly more consistent income | Possibly more variable income |
| Pooled investments | Pooled investments |
| Can be diversified | Diversified |
What’s a mutual fund?
A mutual fund is a public investment vehicle which pools money together from many investors in order to implement an investment strategy which could include buying stocks, bonds, or other assets. Mutual funds give investors access to professional money managers who allocate the funds money on behalf of their investors, often giving investors access to better diversification (reduced risk) than they could have on their own.
Mutual funds aim to make money for their investors from the increase in value of the securities they invest in. Each investor thereby participates in the gains or losses of the overall portfolio of the fund in proportion to their investment.
Essentially, mutual funds allow investors to bet on a group of companies by buying into the fund instead of having to go out and buy all those companies individually. This, therefore, saves them time, money, and gives them access to a full-time professional.
Well-known examples of mutual funds include Vanguard 500 Index Fund Admiral Shares (VFIAX) designed to mirror the performance of the S&P 500, or Fidelity 500 Index Fund (FXAIX) also designed to perform similar to the S&P 500. Both funds have been in operation for 20+ and 9+ years respectively and have more than a $100B market cap.
We cover mutual funds and ETFs with incredible detail in our articles on mutual funds and ETFs.
What’s a hedge fund?
A hedge fund is a private investment vehicle which pools money together from a limited number of high net worth investors in order to implement an investing strategy. Investing strategies for hedge funds can have a much greater variety than mutual funds. Instead of just focusing on one type of asset such as stocks or bonds, hedge funds may actively have both or more. On top of this hedge funds may own some stocks (be long) and sell others (be short) at the same time, engage in options trading, or use leverage to enhance returns.
The investments the hedge fund makes should match up with the fund’s objectives, however, unlike mutual funds the objective is not published to the public. This means the investor wanting to put money into a hedge fund will have to access this information directly from the fund itself if the fund is willing to share it.
Additionally, it is not uncommon for hedge funds to have a certain lock-up period. This means that after making a likely sizable investment into the fund, an investor would not be able to withdraw their investment for a period of years.
The fees
When it comes to expenses mutual funds and hedge funds are very different. Hedge funds usually have a fee structure where the money managers are paid 2% of the invested amount and get to keep 20% of the profits. This means the hedge fund has to perform very well for the fund to return equal to or better than what they could get from regular investing.
Mutual funds have an annual fee, called the expense ratio, of 1% or less. In addition, some mutual funds charge a fee when you buy shares, called a load, which may be around 5% if they have one. Since the fees are much less the mutual fund doesn’t have as much work to do to hit their objective or match an index such as the S&P 500.
The performance
Performance of both is very dependent on their objectives. Some hedge funds seek to have positive returns in bear markets while others may seek to be continuously aggressive in bull markets. Since hedge funds are private, they are subject to much fewer regulations and therefore can invest in basically anything. This means that their performance is dependent on the skill of management and their ability to find investments. In recent years hedge funds have generally underperformed the market significantly.
Mutual funds typically take a much more simplified approach. Sticking to one type of asset and investment objective. Many in recent years have moved to tracking a certain index with the S&P 500 or Nasdaq 100 being most popular. As a result of both a more simple approach and a long bull market mutual funds have broadly performed better than hedge funds.
The accessibility
Having a net worth of $1 million or more not including your house might be a high bar to achieve for many regular investors. This is the beginning of the definition of an accredited investor which are the only investors eligible to invest in hedge funds. Most mutual funds however are open to mainstream investors with an initial investment of almost nothing in some cases.
Which is better?
For most investors, the option to invest in a hedge fund is just not available. The requirements to invest and the initial investment are likely too much. But if they aren’t or if you could, should you? Likely this is a case-by-case answer and really depends on the hedge fund. Generally, though, you would be better off investing in a mutual fund which offers similar or better returns for much less risk.
Speck & Company does not offer personalized financial or investment advice. The information provided is for informational purposes only and without consideration of any specific investor’s situation. When considering an investment, a trusted financial professional may be able to help when considering an investor’s specific situation.
Frequently Asked Questions
Four differences between hedge funds and mutual funds are who can invest, how much the funds charge, what the funds can invest in, and the regulations they must follow.
As of recently, hedge funds have not outperformed mutual funds after taking their fees into consideration. This is broadly speaking and is different on a case-by-case basis.
While it is highly unlikely that you would lose all your money in a mutual fund. There is no guarantee that you will not lose money in a mutual fund. This could be a small amount or a meaningful amount. However, losses are not final until the position is closed.
The main transparency differences between hedge funds and mutual funds are who their reports are made available to. Mutual funds must publish annual reports, performance disclosure, and a prospectus while hedge funds have no such requirement.