Investment funds give people immediate exposure to many assets. As a result, you can quickly diversify your portfolio with minimal effort. Hedge funds and mutual funds are two popular assets for portfolio diversification and returns. You can invest in both funds, but each dollar you invest can only go into one of these funds. Knowing key differences between these investment funds will help you construct a portfolio that aligns with your risk tolerance.
What is a Hedge Fund?
Investors pool their money into hedge funds hoping to beat the market. Hedge fund managers use hedges to limit their downside. These funds may short stocks, buy derivatives, and explore alternative assets. These riskier investment strategies can lead to higher losses or significant gains in any economic cycle.
How Does a Hedge Fund Work?
Hedge fund managers use capital to buy assets and hedges. Hedges offer protection in case the underlying asset experiences unfavorable price movement. Hedge funds are riskier and less liquid than mutual funds. Hedge fund investors have a limited window to invest in a hedge fund and liquidate their positions. Some investors can’t sell their hedge fund positions for months or even years.
Not everyone can invest in hedge funds. These funds are only available for accredited investors. You’ll also have to pay more fees with a hedge fund. Most portfolio managers charge a 2% management fee and 20% of the portfolio’s gains. On the other hand, mutual funds offer lower expense ratios.
What is a Mutual Fund?
A mutual fund is a basket of assets that simplifies portfolio diversification. Anyone can invest in mutual funds, and investors can select from several options. For example, you can find funds that invest in stocks, bonds, crypto, alternative assets, or a combination of these assets. Some investors buy shares in multiple mutual funds to diversify across asset classes.
How Does a Mutual Fund Work?
Mutual funds have less risk than hedge funds. You can find mutual funds that mimic returns from popular indexes such as the S&P 500 and NASDAQ. Mutual funds also have more liquidity than hedge funds. You can enter and exit index fund positions in a day. Investors can trade ETFs, another type of mutual fund, throughout the day.
The SEC regulates mutual funds, and all investment companies must go through this entity before releasing their shares to the public.
Investors can select from several types of mutual funds:
- Active vs. passive mutual funds: Professionals manage active funds and can help you beat the market. Passive mutual funds mimic market returns from a popular index of your choice.
- Load vs. no-load mutual funds: Investors buying load mutual funds pay the broker a commission for their purchase. The broker either receives the commission when you purchase or sell the securities. No-load mutual funds do not have this fee.
- Open-ended vs. closed-ended mutual funds: Open-ended funds have no limits on how many shares they can issue, whereas closed-ended funds offer a limited number of shares. You can trade close-ended funds throughout the day, but open-ended funds only trade and change the price at the end of the day.
Hedge Funds vs. Mutual Funds: Similarities
Hedge funds and mutual funds have many things in common. Both assets provide instant diversification across several assets. Money that flows into these funds goes towards various investments. This diversification mitigates risks and makes it easier to navigate market turbulence. You’ll save time since someone else does the research and portfolio allocation for you. Investors can use the extra time to expand their income, the only guaranteed way to increase your portfolio. You can also spend more time with family and friends or work on a hobby.
Neither of these funds lets you invest for free. You’ll have to pay fees to participate in either type of fund. Portfolio managers for both funds buy long positions that benefit from appreciation. Investors can also monitor historical performance, current allocations, and other details about both types of funds. Portfolio managers will also identify their fund’s objectives. Some funds are high risk and have a potentially high payoff, while others sacrifice high returns for more certainty. Gathering this information before an investment provides them with more context. You can see if a fund had a lucky year or several years of solid performance.
Hedge Funds vs. Mutual Funds: Differences
Hedge funds and mutual funds share a few similarities, but they aren’t identical investment opportunities. These funds have different characteristics that can significantly impact your returns, financial flexibility, risk level, and other areas of your finances.
Investment Strategy
Mutual funds and hedge funds each enter long positions. Long positions benefit when the asset’s price rises and falls when the asset’s price declines. Most investors enter long positions, with buying stocks as a common example. Hedge funds also invest in short positions to weather market volatility. Short positions benefit when an asset’s price declines. A short investor benefits if the shorted asset falls by 15%. This dynamic helps hedge funds make money during corrections and crashes, while mutual funds have fewer options. Hedge funds are riskier but also have the potential to generate higher returns.
Investors
Anyone can invest in mutual funds. You can create an account or join any other brokerage to get started. Hedge funds are more difficult to access. The SEC only permits accredited investors to access these investment vehicles. Hedge fund investors have more money to spare or are corporate entities.
Fees
Both funds charge management fees for managing your money. However, hedge funds also include a performance fee. Most hedge funds charge a 2% management fee and a 20% performance fee. If your hedge fund position increases by $100, the hedge fund’s management will take $20. Hedge funds have lowered their fees in recent years, but you’ll still pay more if you invest in a hedge fund.
Fund Structure
Mutual funds have more regulations than hedge funds. In addition, while mutual funds have a corporate structure, hedge funds operate as partnerships. These structural differences let hedge fund managers make far riskier investments than mutual fund managers.
Liquidity
Mutual funds are incredibly liquid. You can buy and sell shares in a day. ETFs provide even more liquidity, enabling traders to buy and sell shares throughout the day. Hedge funds are far less liquid and have limited windows to make an investment. Once your money is in the hedge fund, it’s not easy to get it out. Most hedge fund managers have an open window once per quarter when you can sell shares, but some hedge funds only provide this opportunity 1-2 times per year.
Returns and Earnings
Both funds can outperform the market, but you’ll find many mutual funds that aim to mimic market returns. Hedge funds employ riskier strategies that can crush mutual fund returns or fall well behind. A hedge fund’s fee structure makes it more challenging to exceed mutual fund returns.
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Hedge Funds:
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Definition and Purpose:
- Hedge funds are investment pools where investors contribute money with the expectation of outperforming the market.
- Hedge fund managers use a variety of strategies, including short selling, derivatives, and alternative assets, to manage risk and potentially generate higher returns.
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Operational Mechanism:
- Hedge funds employ hedges to protect against downside risk.
- They can use short-selling to profit from falling asset prices, making them adaptable to various market conditions.
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Accessibility and Regulation:
- Hedge funds are typically limited to accredited investors, requiring a higher financial threshold.
- SEC regulations govern hedge funds, and they often have limited windows for investors to enter or exit positions.
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Fees:
- Hedge funds usually charge a 2% management fee and a 20% performance fee on profits, making them relatively expensive compared to mutual funds.
Mutual Funds:
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Definition and Purpose:
- Mutual funds are investment vehicles that pool money from various investors to invest in a diversified portfolio of stocks, bonds, or other assets.
- They are accessible to a broader range of investors compared to hedge funds.
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Operational Mechanism:
- Mutual funds offer simplicity and diversification, making them suitable for investors seeking a less complex investment approach.
- They are regulated by the SEC, providing transparency and oversight.
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Accessibility and Regulation:
- Mutual funds are open to anyone, requiring no accreditation.
- SEC regulations ensure that mutual funds follow specific guidelines to protect investors.
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Fees:
- Mutual funds generally have lower expense ratios compared to hedge funds, making them more cost-effective for retail investors.
Hedge Funds vs. Mutual Funds: Similarities:
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Diversification:
- Both hedge funds and mutual funds offer instant diversification across various assets, reducing risk exposure.
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Professional Management:
- Portfolio managers in both funds handle research and asset allocation, saving time for investors.
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Fees:
- Both funds require investors to pay fees for management and operational costs.
Hedge Funds vs. Mutual Funds: Differences:
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Investor Eligibility:
- Hedge funds are exclusive to accredited investors, while mutual funds are open to the general public.
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Fees Structure:
- Hedge funds charge both management fees and performance fees, making them costlier.
- Mutual funds typically have lower expense ratios without performance fees.
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Regulation and Structure:
- Mutual funds are more regulated and structured, adhering to SEC guidelines, while hedge funds operate as partnerships with more flexibility.
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Liquidity:
- Mutual funds, including ETFs, are highly liquid, allowing daily trading.
- Hedge funds are less liquid, often restricting investor withdrawals to specific windows.
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Returns and Risk:
- Hedge funds employ riskier strategies with the potential for higher returns but also greater losses.
- Mutual funds often aim to mimic market returns, providing a more stable investment option.
Understanding these concepts will empower investors to make informed decisions based on their risk tolerance, financial goals, and preferences.
