If you’re new to investing in funds, you might think that hedge funds and mutual funds are the same things. But while they might look similar at first glance, hedge funds and mutual funds are very different.
When it comes to Hedge funds and mutual funds, they may work by combining the money of many investors. They then invest it with the help of a fund manager for a set fee. And that’s the only thing they have in common.
This article breaks down hedge funds vs. mutual funds. It gives you an in-depth explanation of each of them. We also listed what makes them different to help you understand them fully. Keep reading.
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Hedge funds vs. Mutual funds- What are they
A mutual fund is a simple way for individual investors to access a managed portfolio. The portfolio could have stocks and bonds traded on public markets. Investors buy shares of a mutual fund, and the manager of the fund pools the money of all the shareholders. The manager works to meet the goals set out in the prospectus.
A prospectus explains the benchmark index of the manager’s performance. This is usually measured against the strategy they’ll use to invest.
A hedge fund is set up so that individual investors can use the ideas and strategies of fund managers. They usually think the managers have an edge in the market. Hedge funds are set up as general partnerships. Investors don’t buy shares but instead, become limited partners in the investment company.
This is the simplest explanation of Hedge funds vs. Mutual funds
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Hedge funds vs. Mutual Funds- Planned investments
Most people think that mutual funds are safer investments than hedge funds. Fund managers can’t use riskier strategies like borrowing against their holdings. This boosts returns but also makes the market more volatile.
Mutual funds buy securities traded on the stock market based on the manager’s rules. These criteria could be very specific, like buying pharmaceutical stocks that the manager thinks are seriously undervalued. This could be due to certain metrics. Or they could be very general, like buying every stock in the S&P 500 index.
Investors in mutual funds can choose from a wide range of strategies, and the prospectus tells them all about them.
Hedge funds don’t limit how they can make money for their investors and give them big returns. Hedge funds use derivatives like options and margins to get more money. They may also sell short stocks.
Hedge funds can also invest in almost any market. This includes cryptocurrencies, private real estate, and even vintage single malt scotch. These are strategies that mutual funds can’t use because of SEC rules. They are also much riskier than just buying securities on the stock market.
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What are the Different Types of Mutual Funds?
Investors should know about a few different kinds of mutual funds.
Actively managed funds vs. passive funds.
A fund manager usually runs actively managed mutual funds. The manager buys and sells securities strategically to beat the fund’s benchmark index. Passive funds, also called index funds, just try to get the same returns as the benchmark index. They do this by making a portfolio that looks like an index. The fund will sometimes just buy all of the stocks in the index.
Open-ended vs. closed-ended funds.
There is no limit on how many shares an open-ended fund can give out. Investors just buy shares, and when new money comes in, the fund manager puts it in the right securities. Because there are only so many shares in a closed-ended fund, the portfolio manager doesn’t have to deal with money coming in or going out. If you want to buy or sell shares, you must find a buyer or seller on the open market.
Load vs. no-load funds.
Load funds give a commission to the broker who sells the fund to an investor. The investor’s money goes out of their account when they buy the mutual fund (front-loaded). It is also the same when they sell it (back-loaded). No-load funds don’t have this kind of fee.
Hedge funds vs. Mutual Funds- Who can Buy them?
When comparing Hedge funds vs. Mutual funds, you should know that any investor can buy mutual funds. Some funds may require a minimum investment of $100 to $10,000. More and more funds don’t have a minimum amount to put in.
Only accredited investors can put money into hedge funds. The Securities and Exchange Commission (SEC) says that a person is an accredited investor if they have a liquid net worth of $1 million (home equity doesn’t count). They may also have an annual income of $200,000 (or $300,000 with a spouse).
The SEC thinks that an investor’s level of wealth makes them smarter. It may also enable them to handle the volatility and uncertainty of hedge funds.
Most hedge funds have investments that start at $1 million or more. They usually have limits on how much you can invest and can have minimum holding periods. They can also put limits on when investors can take their money out. Because of this, people who invest in hedge funds need a lot of cash outside their portfolio in hedge fund.
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Hedge funds vs. Mutual Funds- How do their fees work?
Mutual Funds
Mutual funds charge a management fee, usually between 1% and 2% of the total amount of money. Fees tend to be much lower for index funds. Some fees for broad-based index funds are close to 0%.
Note that the management fee differs from the fees paid in loaded funds. Here, the broker also gets some of the money from the investors. The management fee goes straight to the company that runs the mutual fund, and they pay once a year.
Hedge Funds
There are two types of fees that hedge funds charge: management and performance fees. A management fee is like the fee that a mutual fund charges to run. The fund has an expense ratio, which is usually 2% of the assets it manages. It is usually taken out every year.
As the name suggests, the performance fee hinges on how well the fund does. It is usually 20% of the gains. So, if the fund goes up by 10% in one year, the fund takes 20% of the gains. This is 2% of the original investment and leaves the rest in the fund. The investors still have to pay the management fee even if the fund loses money. There is no performance fee if the fund loses money.
The most common fee structure is the “2-and-20,” consisting of a 2% management fee and a 20% performance fee.
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Hedge funds vs. Mutual Funds- Rules
Mutual Funds
Before they can sell shares to the public, mutual funds must sign up with the SEC. The Securities Act of 1933, says that mutual funds have to give investors a description of the fund. It must also give information about its management and financial statements. The Investment Company Act of 1940 also says that mutual funds must give information about their finances. They must also show how they invest.
Hedge funds
When they have more than $100 million in assets under management, hedge funds must register with the SEC. Aside from that, they have to follow Regulation D of the Securities Act of 1933 and only let accredited investors buy shares. Because of this, they don’t have to tell the SEC about most of their business. This makes investing in a hedge fund much less clear than investing in a mutual fund.
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Hedge funds vs. Mutual Funds – What are the Major Differences
There are a few big differences between Hedge Funds and Mutual Funds:
#1. Fund Structure
Pooled investment vehicles include both hedge funds and mutual funds. In other words, both of these funds take money from a large number of investors and combine it into a single “fund.”
The money is then invested by the “Fund Managers,” in charge of the Fund. Even though they have these things in common, Hedge Funds and Mutual Funds have very different legal and regulatory frameworks.
Most hedge funds are usually run by the Fund Manager and their Investors as a partnership. Also, Hedge Funds don’t have to follow many rules. This way, they have a lot more freedom to invest in riskier things, as we’ll see in a moment.
On the other hand, mutual funds are usually set up as Corporations. The Investment Company Act of 1940 says how the US government should regulate Corporations. Strict rules mostly govern mutual funds.
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#2. Regulations
As was already said, mutual funds are heavily regulated, and their investors must be able to sell every day. Hedge funds aren’t heavily regulated and usually don’t have problems getting money in and out of them. So, investors in a hedge fund may only be able to get out of their investment once a quarter. Sometimes, it’s for a much longer time.
#3. Fee Structures
In comparing Hedge funds vs. Mutual funds, Mutual funds usually charge a “Management Fee” equal to a certain percentage. Usually between 0.5 and 1 percent of the money they manage. Hedge funds have much more complicated ways of making investments, so their “2 and 20” fees are higher.
The first part of “2 and 20” is a Management Fee of 2% per year. Hedge funds also take what we call “Carried Interest” (or just “Carry”), which is 20% of the profit. Some of the best funds charge even more, with Carried Interest rates of 30 percent or more.
In recent years, competition in the Hedge Fund world has made these fees smaller. This way only the best-performing funds still get the full “2 and 20” fee structure.
#4. “Long/Short” vs. “Long-Only”
If you’ve read any articles about hedge funds, you’ve probably heard the terms Long-Only and Long/Short. These Investment Firms use these two different investment strategies of Hedge funds and Mutual funds.
Mutual funds usually only buy stocks, but there are some exceptions. Hedge funds, on the other hand, also sell stocks, which is why they are Long/Short funds.
#5. Investment plans
Most of the time, hedge funds are riskier than mutual funds. Even though each fund’s investment strategy is different, hedge funds usually try to make money. Whether the market is going up or down. To reach this goal, hedge fund managers can use risky strategies like short-selling stocks. They also take speculative positions in derivative securities.
Mutual funds, on the other hand, can’t use as much leverage. This makes them less risky but also limits their potential returns.
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#6. Holding period
Depending on the fund strategy, the amount of time a hedge fund holds its investments can range from microseconds (like with HFT firms) to years (Global Macro). When you put money into a mutual fund, it stays there for a few years.
Mutual funds have strict rules about how much money you can invest. There are rules on how long earnings should be and how to invest the money.
There are no rules like this that limit hedge funds. Partly because of this, there are strict rules about who can invest in a hedge fund in the first place.
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Summary
Both hedge funds and mutual funds are investment products. They help investors manage their portfolios, but that’s all they have in common. Hedge funds try to make money for their clients by trading with more complicated and risky strategies. They focus on people with a lot of money.
Anyone usually buys mutual funds, but they can only trade in a limited number of things. A mutual fund manager’s main goal is to beat an index used as a benchmark.
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Frequently Asked Questions
It’s your choice. Most people think that mutual funds are safer investments than hedge funds. Mostly because fund managers can’t use riskier strategies like borrowing against their holdings. This can boost returns but also makes the market more volatile.
They buy and sell regularly by anyone. Hedge funds are private investments that only people who have the government’s approval can buy. Hedge funds take more risks with their investments to make more money for their investors.
No. Some funds, like hedge funds, do not register their shares with the SEC. This means they don’t have to follow the same rules as mutual funds. Or other funds registered with the SEC.
Hedge funds can trade in anything they want. These could be
Stocks and derivatives
Land
Real estate
Bitcoin
Public securities
Life insurance
Lottery tickets, or
A mine on the other side of the world.
On the other hand, mutual funds can only invest in publicly traded stocks and/or bonds.
How well a mutual fund does depends on how many investors are in it. Investing in hedge funds is riskier, but it usually pays off better. However, hedge funds haven’t been doing so well lately. Most mutual funds have lower returns and less risk than stocks and bonds.
Over the past 20 years, the hedge funds have done better than the market by an average of 1.5% per year. When they considered fund size, the difference went up to 2.5% mostly because smaller funds did better than big ones. Studies have shown for a long time that the average mutual fund doesn’t beat the market. However, hedge fund managers seem to be able to.
References
- finance-able.com– Hedge funds vs. Mutual funds
- gobankingrates.com– Hedge funds vs. mutual funds
- fool.com– Hedge funds vs. Mutual funds
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