What are the similarities between mutual funds and hedge funds?
Mutual funds and hedge funds have more differences than similarities, but they do share some commonalities.
Professional management
Both mutual funds and hedge funds are professionally and actively managed. Hedge funds are known for their diverse range, while mutual funds pursue more traditional investing strategies.
Returns
The goal for both mutual funds and hedge funds is to produce returns for investors and outperform the market.
Pooled Investments
Mutual funds and hedge funds both use money from a large pool of investors. Large funds can make big moves in the market.
Diversification
Both mutual funds and hedge funds offer a way to diversify your portfolio. Mutual funds offer diversification by investing in a number of different securities. Hedge funds offer diversification in a much different way. Diversification comes through alternative investment strategies, market inefficiencies, hedging, and other methods designed to produce high returns on your investment.
What’s the difference between mutual funds and hedge funds?
Hedge funds and mutual funds are very different investment vehicles.
Here’s a breakdown of their major differences in strategy, fees, regulation, investment amounts, liquidity, risk, and accessibility.
| Mutual funds | Hedge funds | |
|---|---|---|
| Investing strategy/approach | Seeking returns from strategic investments | Seeks to hedge against market risk and produce high returns |
| Fee structure | It has a number of fees and operating costs, but it is nowhere near what a hedge fund charges | 2/20, which is 2% of the net asset value (NAV), plus 20% of the profits |
| Regulation | Regulated by the SEC | Unregistered and private, lightly regulated |
| Minimum investment | Minimums around $250 are common, and fractional investing with a brokerage is possible | High; think $250,000 or more |
| Liquidity | Can trade daily | Limited; may be limited to quarterly redemption |
| Risk | Low risk | Higher risk |
| Accessibility | Anyone | Only accredited investors |
Investing strategy
Hedge funds can pursue a wide variety of strategies and, since they’re less regulated than a mutual fund, have more flexibility in what they can do. They can take long and short positions on equities, take positions on commodities or currencies, make bets on the market from corporate or national news, take advantage of price discrepancies, invest in distressed securities that have an upside potential, and so much more. Mutual funds invest with the goal of producing strong returns for investors with more traditional methods.
Fee structure
Hedge funds are known for a 2/20 fee structure: 2% of assets under management (AUM) annually and 20% of profits. There’s been downward pressure on fees in recent years, but you can still expect to pay hefty fees for investing with a hedge fund. Mutual funds also charge fees, but are closer to 1%.
Regulation
Hedge funds are only lightly regulated. Mutual funds are subject to regulations that require disclosures on investments, conflicts of interest, limited leverage, fair pricing of shares, and more.
Minimum investment
Hedge funds have a very high minimum investment requirement. Most are around $250,000 in investable assets with additional requirements for net worth and yearly income. Mutual funds typically require an investment of $250 to $3,000. Fractional investment may be possible through a brokerage, in which case you can invest in a mutual fund for as little as $1.
Liquidity
Mutual funds can be redeemed daily, whereas redemptions for hedge fund shares are limited to quarterly (and sometimes less frequently).
Risk
Hedge funds take on a lot more risk. They also offer greater flexibility and specialization, which may produce returns in both bear and bull markets, amid economic uncertainty and other global events.
Accessibility
Hedge funds are only open to accredited investors, qualified clients, and institutional investors. There are minimum investment, income, and net worth requirements, as mentioned previously.
What are the pros and cons of mutual funds vs. hedge funds?
Mutual funds and hedge funds offer different things.
Here’s a summary of the pros and cons of each type of investment.
Mutual funds
Pros
Professionally managed: Mutual funds are actively managed by professionals to produce competitive returns.
Different types of mutual funds: Mutual funds offer a variety of investing strategies. You might see mutual funds focused on the tech sector or on income.
Simplicity: It’s easy to find and buy mutual funds with a brokerage of your choice. You may already have exposure to mutual funds through your employer's retirement portfolio.
Diversified investment: Mutual funds offer diversification by combining various investments.
Cons
Costs: Mutual funds often come with a number of fees that reduce your returns. However, they’re usually significantly lower than the hedge fund fee structure.
Not as tax-efficient: Mutual funds may generate taxable events, such as dividend income or capital gains.
No guaranteed returns: Mutual funds are actively managed, but many do not outperform the market, and there’s always market risk.
Hedge funds
Pros
More flexibility: Hedge funds don’t have to follow the same regulations that ETFs and mutual funds do, so there’s more flexibility with how the fund can pursue returns.
Potential for higher returns: Hedge funds can deliver higher returns, but it’s also possible they’ll underperform the market significantly.
Possible to make money in down markets: Hedge funds operate with the goal of creating returns with any number of strategies, such as short selling,
Helps diversify your investments: Hedge funds can help fill gaps in your investment portfolio.
Access to alternative investments: Hedge funds may pursue alternative investments for increased profits.
Cons
High fees: You’ll pay 2% of the net asset value (NAV) for a management fee plus 20% of the profits.
Higher risk: Hedge fund positions take on risk at every step. It can pay off big, but you could also lose big.
Less transparency: Hedge funds are not required to disclose their holdings, and assets are harder to sell.
Less regulation: Hedge funds are not registered investments, so there’s no protection against conflicts of interest, no requirement to redeem daily, may not be priced fairly, aren’t required to disclose information to investors, and don't have limitations on leverage.
Less accessible: Hedge fund investing is limited to accredited investors, with a very high minimum investment requirement.
Redemption limitations: Hedge funds typically only allow redemptions four times per year (or fewer). They can also suspend redemptions during turbulent markets, which could leave your money in bad positions.
Leverage: Hedge funds can use more leverage than mutual funds, thereby amplifying gains. It can also multiply losses.
Should I choose a mutual fund or hedge fund?
Mutual funds and hedge funds are vastly different. Most investors looking at one are not looking at the other. If we look at the goals of the two types of investors, it might become clearer which one you’re leaning toward.
Typical investors for mutual funds are looking for:
Professional management
Diversified investments to build their retirement portfolios
Relatively low-cost investments
Passive investing strategies
Fair and transparent trades
Typical investors of hedge funds:
Desire higher returns above all else
Have a higher tolerance for risk
Are accredited investors
Have a large minimum available to invest (Think at least $100,000 in investable assets)
Understand the complex investment strategies hedge funds use
Have a tolerance for a much higher fee structure
May be institutional investors
Hedge fund investors tend to have higher amounts to invest and expect higher returns.
You need to be an accredited investor and have at least $100,000 to invest (though it’s usually much higher). Hedge funds use complex trading strategies to minimize losses, but these strategies also come at a cost. The risks are higher, so you could end up losing more money.
Bottom line
Investors of mutual funds and hedge funds are usually in different stages of their investing journey. Hedge funds may deliver higher returns, but they also entail greater volatility and risk. The lack of transparency could be frustrating, and your money could be locked up in a hedge fund. Mutual funds are considered a safer and more accessible investment for your retirement money.
Consider consulting with a financial advisor before investing with a hedge fund. They have the experience, knowledge, and know-how to help you with your money goals, and there may be alternatives that better suit your needs.
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